When it comes to successful investing, there is no goose that lays the golden egg. So, while passive versus active investing is often presented as a simple either/or, in reality there should never be a binary choice between active or passive investment vehicles as the sole solution to your investment needs.
This said, it’s important to understand the arguments surrounding passive versus active investing, and why, despite the growing popularity of passive products, there should always be room for active investments in your portfolio:
Passive providers often bandy around the statistic of how more than 50% of active managers underperform the benchmark. However, they never quote their own result against the same measure, because 100% of passive products underperform the same benchmark by at least their cost. So some active managers underperform, but all passive managers do.
The counter argument, of course, is that at least the size of passive managers’ underperformance is known upfront, whereas the variability of the active managers’ performance is not known. At the same time, it’s important to remember that active managers outperform as well.
Furthermore, these statistics demonstrate survivorship bias in that while poor managers usually end up closing shop, their poor numbers usually remain in studies – even though they are no longer available as investments.
A more appropriate analysis would be to examine the percentage of active managers who are open for investment today that outperform passive products on an after-cost basis.
Passive product providers often compound their theoretical cost-savings over long periods of time and highlight the amount in absolute terms. And indeed, the cost characteristics of passive products are highly attractive, and should be used in asset classes where it’s possible to sensibly apply them, like in core holdings of equities.
It doesn’t, however, make logical sense to use passive products in asset classes like fixed income, foreign exchange and physical commodities, where an active product is far superior.
Additionally, the longer the investment horizon, the more likely that an active manager would outperform their passive peer, so making a blanket “saving” assumption could be very costly indeed.
Passive investing discards all investment wisdom obtained throughout the last century, all for a single standard: it’s cheaper. And while cost is, of course, an important factor, using costs as your first or only investment criteria inevitably leads to poor decision-making.
Here is some common investment wisdom, and how passive investing ignores this wisdom entirely:
Rule number one – don’t lose money: Passive solutions are ambivalent to market direction.
“This time is different”: These are perhaps the four most dangerous words in investing, which passive solutions disregard by buying most of whatever is currently in favour.
The importance of valuations: Passive solutions only acknowledge price and disregard valuation entirely.
Risk vs reward: In investing, what is comfortable is rarely profitable. However, there’s no choice in passive investing.
Know what you own: Knowing or understanding what you own and why you own it is an irrelevant factor in passive products.
Don’t overdiversify: Wide diversification is only required when investors want to avoid the hard but important decisions around their portfolio construction. Passive solutions are the most diversified of all, as they represent the entire market.
Passive providers also fail to highlight a host of other issues which are extremely important to an overall investment solution. These include:
Philosophy: Passive investment holdings are usually weighted according to the market capitalisation of each company. This means that passive investors often land up buying the most expensive shares, because there’s no investment philosophy underlying investment decisions. This could severely impact an investor’s long-term results.
Risk management: Passive vehicles do not offer risk management, where active managers can move rapidly when unexpected risk events take place.
Asset allocation: Fully passive solutions do not offer asset allocation as part of the management process. Furthermore, the actual choice of your strategic asset allocation is in fact an active decision.
Balance is the key
Ultimately, the success of an investment solution lies in achieving the objectives you have set out to achieve. The investment objectives of investors vary dramatically, so no two investment solutions can be exactly the same, yet both can achieve their objectives.
It is important to remember that both active and passive products are required to create an optimal investment solution for each and every client, understanding that the investment objective will determine what proportion of both these applications should be used in any specific solution.