There has been increasing discussion in recent years about whether active or passive investment management "wins out" in the long run. With famous investors such as Warren Buffet stating that "a low-cost index fund is the most sensible equity investment for the great majority of investors", while himself taking a decidedly active approach to investment management. When asked whether indexes like the S&P 500 will have less significance, Larry Fink, CEO of Blackrock, the world's largest asset manager and provider of passive ETFs responded that "yes [he does]… better reporting [and] better disclosure creates better data, and better data will allow… better analysis of each company." Fink says that "more of the public pension funds… are going to move large pools of their money away from the traditional index to a more customized index that meets their participants desires and needs." It sounds like a famous active investor is advocating a passive strategy, and a famous provider of passive investments is advocating a more active strategy.

 

What is Passive Investing?

In technical terms, passive investing refers to a strategy whereby investors take a long-term approach to investing with little to no portfolio turnover. In recent years, passive investing has been most closely associated with index investing through low-cost ETFs. Index investing usually involves holding funds that trade on traditional stock exchanges (ETFs) that are designed to track market indices at a low cost, without the need for purchasing each underlying security in the index individually and maintaining the representative allocation of each.

 

What is Active Investing?

In simple terms, active investing involves changing and updating the contents of an investment portfolio on a continual basis. Active investing has been more recently associated with managed investment vehicles (often mutual funds) or "stock picking" advisors that involve higher fees with a stigma of false promise that investors achieve a higher return on investment as a result.

 

So what's better; high fees in hopes of a high return, or low-cost replication of the index?

 

My most basic answer to that question is to:

1. Follow the data
2. Have a strategy
3. Adhere to the strategy

 

Follow the Data

It's easy to pick a camp and say that passive or active investing is a superior method. In reality, there is a spectrum between passive and active investing. Few investors purchase one broad market replicating index ETF and hold it for the duration of their lives, and few investors are successfully day trading their retirement savings. Typical portfolios contain a blend of both passive and active investment vehicles, but it's important to consider where and when is appropriate for each. A cohesive portfolio of diverse investment vehicles is typically the most consistent way to optimize the risk/return equation toward an investor's goals, whether that investor is an individual or a large institution (such as a pension fund or family office).

 

It is certainly not unheard of for experienced portfolio managers dealing in a disciplined mandate to outperform their benchmarks. To avoid any perceived bias, I won't specifically reference any currently available mutual funds, hedge funds, separately managed portfolios or ETFs. A great example of a portfolio manager and his team outperforming their benchmark is Peter Lynch with the Fidelity Magellan fund between 1977 and 1990. During that 13 year period, the Fidelity Magellan fund returned 29.2% annually - double that of its benchmark, the S&P 500.

 

This however does not mean that we simply go looking for whichever investment vehicle/product has the highest historical return. To understand why, I'd like to introduce two more technical concepts: portfolio alpha and portfolio beta.

 

Portfolio beta is a measure of the change in portfolio value that is directly correlated with a change in the overall market, i.e. that portfolio's benchmark index. Portfolio alpha, is the change in portfolio value that is uncorrelated with the overall market. This is determined through a statistical regression, and both values are typically available for all managed investment products and most discretionary portfolios. In short: for an actively managed portfolio, portfolio beta is the portfolio's sensitivity to its benchmark; portfolio alpha is the portfolio's excess return in relation to the market (sometimes portfolio alpha is negative). Index tracking ETFs are by nature designed to track their benchmarks on a 1:1 basis. As such, they seek to have a portfolio beta of 1, meaning a 1% increase (or decrease) in their benchmark leads to a 1% increase (or decrease) in the value of the ETF. Portfolio alpha for an index tracking ETF would be comprised of the management fees and expenses (usually quite low for an index tracking ETF), combined with the tracking error - the manager's deviation from their target. What does this mean for investors looking to follow the data? It means that the place for actively managed investments is when we can determine that there is a reliable case to do so.

 

Have a Strategy 

Specifically, a strategic asset allocation strategy, which may allow for tactical asset allocation. What's the difference?

 

A strategic asset allocation strategy dictates the portion of your overall portfolio that you dedicate to each asset class. For some investors this may be as simple as the proportions of their portfolio that comprise of stocks, bonds and cash. For others, asset allocation strategies may include more narrow and diverse asset classes such as exposure to certain geographies within each asset class (broadly such as emerging vs developed market, less broadly such as North America, Asia, Europe, or more narrowly such as Canada, US, China), hedge funds, preferred shares, common shares, traditional government and/or corporate bonds, asset backed securities, cryptocurrencies, real estate etc. Asset allocation strategies may also define investment process such as growth and value factors, or exposure to specific industries such as technology, healthcare, materials, energy, manufacturing, etc. Each of these asset classes and sub-classes have corresponding benchmarks, and exposure can be achieved by either tracking each benchmark, employing an active manager, or a combination of the two.

 

Tactical asset allocation strategies are short term deviations from an asset allocation strategy, and should only be employed when there is a valid, data driven reason to do so, typically as a result of macroeconomic factors or short-term changes in investor needs. For example a corporation may need to employ a tactical asset allocation strategy pending the result of a litigation outcome to ensure cash is available. During the coronavirus pandemic we saw large banks raise cash reserves to account for their potential need to cover loan losses, only to eventually revert back to their long term asset allocation strategy when the scale of defaults did not meet the most dire potential.

 

Two other important factors when considering an asset allocation strategy:

1. It's important to note that an asset allocation strategy is not a financial plan or wealth management strategy, though for individual investors a financial plan may be a factor in determining asset allocation.
2. It is important for an asset allocation strategy to include a method of determining when and how the strategy itself is reviewed and revised if necessary, whether on a time-based schedule, a deviation-based schedule, or some combination of factors.

Adhere to the Strategy

Going back to the example of Peter Lynch and Fidelity's Magellan fund between 1977 and 1990. During that period you may be surprised that the average investor in the fund lost money! How can that be if the fund returned an average of 29.2% annually over the period? If we fail to adhere to our strategies, we tend to chase returns. In the case of the Magellan fund, the average investor contributed to the fund near its top and redeemed their investments closer to the bottom. This is typically the result of cognitive or emotional biases that can be combated with strict adherence to a broader strategy.

 

Another important aspect in adherence to the strategy is portfolio rebalancing. As time goes on and the value of each underlying asset changes, portfolio rebalancing is necessary to adhere to an asset allocation strategy. Take this basic example: if we start with a portfolio consisting of 70% equities and 30% fixed income and go into a period of economic instability reducing equity valuations and increasing those of fixed income assets (as was the case in April of 2020), we may find ourselves with a portfolio that now consists of 55% equities and 45% fixed income; no longer adhering to the original asset allocation strategy. If we then failed to rebalance the portfolio, our significant under-exposure to equities would have impeded our ability to take part in a potential recovery in the value of equities (as was the case in the latter half of 2020). The same effect can be seen during a large run-up in equity valuations, albeit inversely; a reality that escaped many leading into the US trade dispute with China in 2018, on the heels of an historic bull market that drew investors away from their long-term allocation strategies.

 

Above all, it is important to consult your professional advisors for guidance in their respective areas of expertise. A strong advisory team listens to and understands what is important to you so that you can work together, leveraging their expertise to translate your needs, priorities and expectations into a plan and strategy that you can count on; whether you're an individual investor, or representing a broader institution.

 

 

 

 

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