Active Versus Passive Investment Management

Active Versus Passive Investment Management

Quite often I pick up popular financial publications reporting the results of another study showing that active investment management does not work. Unfortunately, many of these studies state conclusions that are much stronger than the underlying data and statistics actually show. On the other hand, there are a number of solid studies such as the classic Brinson, Hood, Beebower and Singer works and the more recent work by Ibbotson, Xiong, Idzorek and Chen (all published in the CFA Institute’s Financial Analyst Journal) that effectively demonstrate that relative to the asset allocation decision, active management decisions such as tactical asset allocation and security selection contribute less to the variability of returns. We should not conclude, however, that active management is not worthwhile.

Let’s examine where I think some studies overstate their conclusions regarding active management. Many studies look at aggregate performance of investment managers such as mutual funds where the data shows that the average return of these investment managers is equal to or less than the return of the relevant index/indices. They then conclude that active management does not work and that investors should invest passively.

What’s wrong with this picture? Let’s look at a simple world. The world consists of $100 billion of investable assets in several asset classes. In this world there are only two investment managers each managing 50% of the world’s investable assets. Both investment managers invest in the same asset classes in the same proportion to the market but actively select the proportion of each security within each asset class. Further let’s initially make the very strong assumption that there are no fees or expenses. Over a recent multi-year period the performance of the managers and the world portfolio is:

Manager A: 8%

Manager B: 12%

Average Performance/World Portfolio/Index 10%

Note that the average performance of the two managers is equal to the world portfolio which is also the world index since there are no fees and expenses. What can we conclude from this example? We can conclude that on average all (in this case both) investment managers do not outperform the world/index.

What can we NOT conclude? We cannot conclude that active management does not work. Clearly in this example one manager has outperformed the other and active management did matter in this example.

The key here is that when we look at large populations of managers we should expect that on average they will not outperform the market. In fact, if there were no fees or expenses then the aggregate average performance of all managers, passive and active, will equal the index. With the existence of fees and expenses, the aggregate average performance of all managers, active and passive, SHOULD underperform the index by the average of fees and expenses. We do not need to do a study or perform any analysis to make this determination. The figure below demonstrates what we should expect:

The keys questions to consider are “Can individual managers (not the average manager) sustainably outperform their index after all fees and expenses (including taxes), and how can we identify those managers?” What matters most is performance after expenses – if an active manager can outperform after expenses and if the risk of that investment matches the risk tolerance of the investor then active management is worthwhile. Performance analytics tools, including performance attribution techniques and quality control charts, enable us to answer both questions. If you are interested in these and other performance measurement and evaluation topics there is a monograph on manager evaluation and selection available from the CFA Institute Research Foundation at https://www.cfainstitute.org/-/media/documents/book/rf-publication/2013/rf-v2013-n4-1-pdf.pdf

It is clear from the last decade that many investors are embracing active management and indexing due to its ease and low cost. For the average investor who does not have the time or inclination to evaluate active managers, the best approach is indeed a passive low cost index. However, this should not lead to the conclusion that no one should actively manage portfolios or select active managers.

Is active management dead? Will active management disappear as more investors embrace a passive approach? I doubt it. In fact, good active managers should embrace this trend – the more investors that invest proportional to current asset prices/weights without diligent fundamental analysis, the more opportunities will exist for active managers.