Miles on Money: Active versus passive investing
Friday, March 28, 2014 7:00 AM
In the ongoing debate over active versus passive management, most of what we read these days is a recitation of old analysis and settled opinions. Those who favor passive management proclaim that markets are efficient and that actively managed mutual funds underperform their indexed alternatives. Active managers are rightly skeptical of the efficient-market hypothesis but too frequently sound like Annie when she courageously proclaims, “The sun’ll come out … tomorrow!”
Still, the war continues, with recent battles going to the passive camp. Passive strategies – increasingly offered through exchange traded funds, or ETFs – continue to take market share. The ETF industry is growing 25-plus percent annually. But active management still accounts for more than four of every five dollars invested in U.S. equity mutual funds.
Where do we come out? Well, Miles Capital is an active manager of stocks and bonds, so you can guess that we find value in active management. But we also invest client assets in ETFs where appropriate.
As we see it, the active versus passive debate is oversimplified. Yes, they are different approaches. Google the terms, and you will read that passive managers try match the index, and active managers try to beat it. That’s OK as far as it goes, but there are many active managers who are more focused on meeting investor objectives than on beating a particular index, and who care as much about risk of loss as they do performance. In short, not all managers – and in our view, very few investors – live in a relative return world.
Passive management, on the other hand, is, well, not so passive. A lot of active decision-making goes into creating and managing market indexes. Take the Standard & Poor’s 500. It’s hardly a static portfolio. Changes in market cap and shares outstanding lead to rebalancing. Corporate actions and market developments cause regular changes in the lineup.
On top of changes to the underlying index, there is the matter of implementation. Do the ETF’s managers buy all of the stocks in the index on the same day and in the same weight as the index? Do they buy a sampling? Do they use derivatives? Each of these decisions requires action.
What is truly blurring the distinction between active and passive has been tremendous growth in the ETF industry, which now has $1.7 trillion invested across more than 1,500 products. In the early days, ETFs were constructed to mirror established indexes. Today, new and increasingly esoteric indexes are being created at a breakneck pace for the specific purpose of launching new ETFs. This development turns the very notion of active versus passive on its head.
We also note growing evidence that the right type of active management can outperform passive strategies. According to a 2013 article by Antti Petajisto titled “Active Share and Mutual Fund Performance,” managers who take large but diversified positions away from the benchmark index – what he calls “Stock Pickers” – significantly and persistently outperform passive strategies. Unfortunately, too many “active” managers are really closet indexers or only moderately active. Petajisto found that from 1990 through 2009, active equity funds underperformed passive funds by 0.41 percent per annum after fees. Stock Pickers, by contrast, outperformed by 1.26 percent per annum net.
Frankly, asset managers haven’t done themselves a favor by agreeing to be measured in relation to an index, because the only way to outperform is to invest differently than that same index. Investing to beat an index rather than to generate superior returns is truly a loser’s game, especially when you consider that clients aren’t really happy to lose 8 percent of the value of their portfolio just because the relevant index lost 10 percent.
Rather than debating the narrowing gap between active and passive, we prefer to direct our efforts toward identifying attractive investments that meet client objectives.
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