The view on passive

Debates over whether markets are better accessed via passive or active strategies have raged for years. During the past decade and a half, on balance, passive funds – undoubtedly one of the most revolutionary innovations in investment history – have earned the bulk of the positive headlines.

This is perhaps understandable, given that these funds have usually outperformed their more expensive active counterparts since the global financial crisis (GFC). For example, as Figure 1 shows, funds in the Investment Association Global sector more than doubled investors’ money between the end of 2007 and August 2022 – itself no mean feat – but funds invested in the MSCI All Country World Index comfortably outstripped even this strong performance.

As discussed in Beyond 60/40, the first article in this series, this was possible because the period between the GFC and the multiple crises of recent years in many ways marked the height of the golden age of investing. Modest inflation, historically low interest rates and supportive central bank policy created a highly conducive environment for a classic 60/40 portfolio invested in generic passive indices.

Of course, passive funds rarely beat the market. They instead attempt to replicate – or “track” – the performance of an index or indices that might consist of dozens, hundreds or even thousands of equities or bonds. The unlikeliness to outperform may matter little, if at all, when the market is thriving.

However, as we also observed in Beyond 60/40, the level of returns delivered by equities during the golden age is unlikely to be seen during the years to come. In tandem, overall risk is likely to increase. Such circumstances might not lend themselves to a purely passive approach.

In addition, passive funds, to a greater degree than active funds, can entail concentration risk. This means they can be excessively exposed to assets that move in an unfavourable direction en bloc. Going forward, this could also become more of a concern.

By way of illustration, consider a fund that invests in a major index dominated by large-cap technology businesses. As was the case in 2022, performance is likely to suffer if events somehow have a negative impact on almost all such companies.

From all this, broadly speaking, we might infer there are two situations in which a passive investment strategy is best used. The first is when it offers an implementation advantage – say, when it enables easy access to a suitably diverse range of investments. The second is when it offers a cost advantage – that is, when it can achieve similar results to active management but with lower fees

The view on active

The principal criticism of active management is well known: it is more expensive than passive investing yet often delivers less performance. This state of affairs has underpinned attention-grabbing headlines such as “Why do we still bother with active funds?”, “Active managers: no place to hide” and even “Most active fund managers should quit”.

Yet it is not necessary to go far into the past to find a different story. Between 2000 and the end of 2007, for instance, active funds held a clear performance edge in the battle between the Investment Association Global sector and the MSCI All Country World Index. So when and why is active management likely to realise its full, market-beating potential?

Arguably, this should occur when the differential between the best-performing and worst-performing equity sectors becomes significant. Extreme occurrences of this phenomenon – known as value dispersion – punctuated even the golden age.

We saw this happen, for example, in the wake of the dot-com bubble burst. Technology stocks plunged by 40% in 2000, while healthcare stocks went up by 30%. Actively managed funds duly held sway for the next seven years.

We also saw it during the post-GFC recovery, when tech experienced a substantial rally and utilities lagged. On this occasion, though, the unprecedented scale of central bank intervention may have tempered active managers’ capacity to weed out big winners and major losers ­– for the simple reason that almost everything seemed to be winning big.

More recently, we saw marked value dispersion at the height of the COVID-19 pandemic. Lockdowns and the mass migration to working from home provided tech with another sizeable surge by encouraging even more hyperconnectivity, while the energy sector was left struggling after the collapse of travel sent oil and gas revenues plummeting.

Relatedly, a further appeal of active management may be that, unlike passive investing, it recognises the innate inefficiency and irrationality of markets and their participants. It is inefficiency and irrationality that produce booms, crashes and the day-to-day pricing anomalies on which good stock-pickers can seize.

This may involve drawing on in-depth knowledge of businesses or sectors that are under-researched and, as a result, undervalued. Such insights could be particularly useful when exploring opportunities at the lower end of the market-cap spectrum or in more specialised areas such as emerging markets, alternative credit and real estate.

The case for a blended approach

The narrative around passive investing and active management has almost invariably been framed in binary, near-confrontational terms. Investors could therefore be forgiven for thinking of this merely as an issue of one side being manifestly superior to the other.

Yet this need not be a stark question of “either/or”. Contrary to the vast majority of the headlines, claims and counterclaims that have accumulated over the years, it can instead be a question of “and”.

In other words, because each strategy has its own strengths, it may make sense to try to utilise the best of both worlds by employing a blend of passive investing and active management. This could be especially prudent amid the uncertainties of the post-golden age.

Taking full account of the relative pros and cons described in the preceding sections, we believe it can be advantageous to invest passively where there is an implementation or cost advantage – as explained earlier – and actively where there is most scope to make a difference in performance. Figure 3 shows how this might work.

So why might an investor adopt a 100% passive approach to, say, global government bonds, as in our illustration? Since the global government bond market is the largest bond market in the world, ease of access and lower cost could be factors. Maybe above all, historically, government bonds have generally been regarded as among the least risky investments.

Equally, why might an investor favour a 100% active approach to, say, UK equities, also as in our illustration? As remarked in the other articles in this series, there may be merit in investing right across the market-cap spectrum – including smaller, lesser-known businesses whose attractions are not widely appreciated. The brightest long-term opportunities may take some unearthing and are unlikely to feature in major indices.

Crucially, none of this is to suggest there is a definitive balance to be struck between passive and active for any given asset class or across a portfolio. Depending on market conditions and other considerations, any number of blends of the two may prove effective.

As we have sought to emphasise throughout this series, the key point is that the need for creative and flexible portfolio construction and asset management is greater now than it has been for a long time. Investors have to acknowledge that what worked well in the past might not work so well now or in the future. To quote baseball legend Babe Ruth: “Yesterday’s home runs don’t win today’s games.”

Conclusion

In this article we have tried to shed fresh light on the long-running debate surrounding passive investment and active management. Explaining why this does not have to be a matter of one clearly being better than the other, we have made the case for both.

We have demonstrated how a combination of passive and active strategies may be applied across a multi-asset portfolio that recognises the full breadth and depth of the investment universe. We believe using such a “blended” approach within and between traditional and non-traditional asset classes can help investors address the challenges of the post-golden age.

The arguments presented here further underline how the demands of investing have moved on from the lengthy period in which a classic 60-40 portfolio, often invested in a limited number of generic passive indices, was routinely able to flourish. As stressed previously, it would be wrong to suppose such a portfolio will never again deliver attractive performance – anything is possible, after all – but it would be equally unwise to ignore the ever-mounting evidence that investors need to think differently in a world increasingly defined by new normals.