Our Approach to Active and Passive Investing

At the center of the controversy is the concept of market efficiency:

• Passive investors believe that the market is efficient, which means that a current security price reflects all available information. Since they assume there is no advantage to be gained by picking stocks or bonds, passive investors buy the entire market or market segment by holding index funds or exchange-traded funds (ETFs) that track the relevant index.
• Active investors assert that the market is less than efficient: They think that they may be able to uncover information not already reflected in a security’s price and thus profit by it. Active investment managers believe that results arising from their security selection and portfolio allocation decisions justify fees that are higher than those charged by passive managers.

This paper takes a close look at active and passive investment approaches, focusing on:

• Trends and projections in active and passive assets under management
• The opportunities and risks of active and passive investing
• Our conclusions about using active and passive investments in client portfolios

Active versus passive market share

While the argument over which approach generates better outcomes has persisted for years, one thing is not up for debate: Investors have been flooding into indextracking strategies over the last several years. According to Cornerstone Macro, LLC (a research firm that provides economic, policy, and strategy analysis) using mutual fund and ETF data, passive investments in 2016 accounted for 21% of assets under management in the US, up from approximately 5% as recently as 2006.

The heightened interest in passive investing shows no signs of ending soon. In 2017, Greenwich Associates surveyed portfolio managers, chief investment officers, and analysts at investment management companies across the United States, Europe, and Asia and found that asset managers believe the shift into passive strategies will continue for many years (“Competitive Strategies for Active Managers,” 3Q 2017). Almost three-quarters of respondents expect passive strategies will capture at least 40% of the overall market, and nearly 25% think it will be closer to 60%. These responses indicate an overall expected passive/active ratio of 55:45. Greenwich’s findings are consistent with Moody’s projections, which indicate that passive investment strategies are poised to exceed 50% of US assets under management sometime between 2021 and 2024.

What’s driving the interest in passive investing?

The surge in interest in passive investing has been driven largely by three factors: cost, performance, and changes in regulations.

Cost: Passive strategies attempt to replicate an index and provide returns close to the index’s – not better or worse. It’s typically easier to mirror an index rather than create a strategy to outperform it, which results in a cost advantage for passive strategies over active, as shown in the table below.

Performance: Another reason for the growing interest in passive investing is performance. Over the last several years, many active managers have had a difficult time outperforming their benchmarks.

We must note here that active managers have not always failed to beat their benchmarks, and it may not be the case that they underperform in the future. As we will show later, there have been many extended time periods when active managers have surpassed their benchmarks. Still, it’s understandable that investors today ask: Why pay more for an active manager who can’t outperform a lower cost passive manager?

Changes in the regulatory environment

Regulations have also helped shift investors into passive funds. Under the new fiduciary rule of the US Department of Labor (DOL), investment advisors for retirement plans will be required to act as fiduciaries to ensure that investments are in the best interests of their clients rather than merely suitable for them. In practice, it will make it more challenging for advisors to place their clients into higher-cost products, while using low-fee index products can mitigate an advisor’s risk. While full rollout of the rule has been delayed, we expect that the pressure for migration to the fiduciary standard will continue. The Securities and Exchange Commission (SEC) is also considering application of the fiduciary rule to investment advisors of non-retirement products, and both the SEC and DOL have unceasingly pushed for more transparency in investment fees.

The case for active management

The experience over the last few years may seem like the death knell is sounding for active investing. But there are risks and potentially lost opportunities with index-tracking investments – it’s not all upside – and recent trends do not tell the whole story. There’s a good case that active investing has a role to play in portfolios.

Performance cyclicality

As noted earlier, active managers have delivered superior relative returns during prolonged periods. While passive funds have posted higher returns over the last several years, active and passive strategies have exchanged the lead in performance over a longer timeline.

The table to the right shows how the leadership role has been swapped in the domestic large-cap category from 1985-2016.

The bottom line

Performance leadership is cyclical.

When it seems that one approach is consistently winning, market conditions change and roles reverse.

Concentration risk

This risk arises from the very nature of index construction. Many indices such as the S&P 500 are market-cap weighted, meaning that stocks in the index are included in the same proportion as the total value of the companies represented. As a result, passive strategies based on market-cap weighted indices force investors to buy stocks with expensive valuations and sell cheap ones – that is, to buy high and sell low.

When markets are driven by a handful of companies or sectors, investors buying index-like investments may be more exposed to companies or sectors than their risk profiles warrant. That can be a serious problem, especially in down markets when overweighted, overpriced stocks begin to fall. We saw this in the 1970s with the energy sector, in the 1990s with technology, and more recently with financials. The lesson to be learned is that costeffective portfolio diversification – one of the major putative benefits of index investing – may not always be present in passive strategies.

Narrow vs. broad markets

A narrow market exists when only a few stocks or sectors are driving the growth of a market, making it more difficult for active managers to outperform their benchmarks. Simply put, there are not enough winning securities to pick unless an investor concentrates his or her holdings and takes excessive risk.

Markets are not always narrow, however: A wide range of equities can often drive the growth of an overall market. In a broad market surge, active managers have more opportunity for success than in a narrow market because the universe of possible winners is much bigger. A broad market opens up the potential to add value based on security selection and decisions to overweight or underweight sectors.

Portfolio Flexibility

Active management gives investors the opportunity to hold portfolios that reflect their preferences. Owning all the securities and all the segments of an index based on an index weighting may not be an attractive prospect for many investors. The value of portfolio flexibility can be especially evident during market corrections, where active managers have the capacity to make adjustments to mitigate losses. For example, as shown earlier, active large-cap blend managers outperformed their passive counterparts in each of the four down-market years from 2000 to 2016.

Change in Central Bank Policy

Following the global financial crisis, interest rates in the US and other major economies reached historic lows – even negative in some countries – driving investors into equities in search of richer returns. One of the unintended consequences of the unprecedented amounts of central bank intervention – also known as quantitative easing – has been the increase in correlations for the vast majority of risk assets, i.e., stocks. The monetary policy boost helped drive stock prices up all along the risk spectrum irrespective of the company’s underlying fundamentals, in several instances. As the Federal Reserve and other central banks begin to reverse their ultra-accommodative policies, correlations should weaken, marginal companies should struggle, and active managers have a better chance of outperforming their benchmarks.

Active and passive investing: Building portfolios for wealth creation

In our view, there are no conclusive findings telling us that either active or passive investing is a clear and consistent winner. In fact, we believe that the active versus passive debate is a potential distraction. The most important challenge investors face is putting a disciplined goal driven strategy in place – one that incorporates objective analysis and research – and then sticking to it.

Traditional economic thinking and the efficient markets theory are based on the premise that people are well-informed, unemotional, and rational in their financial decision-making. However, an extensive body of research has shown the many ways in which humans systematically fail to behave as traditional models predict. A relatively new field, behavioral finance (or behavioral economics), has helped us understand that an individual’s behavior is affected by numerous cognitive and emotional biases. We are often unaware of these biases, making it extremely difficult to make optimal decisions and underscoring the importance of having a time-tested investment strategy grounded in fact-based research.

We believe our clients are best served by a disciplined approach that incorporates both approaches. As noted earlier, performance leadership is cyclical. Passive investing has had a performance edge in recent years, but that does not lead us to predict that it will always outperform in the future. The existence of market corrections and financial bubbles provide evidence that markets are not always efficient, making a case for active investing. In addition, many markets have a wide dispersion of returns, thus representing areas where research and active management could add value. For example, domestic small-cap stocks, non-government fixed income, and international equities – especially in emerging markets – offer significantly broad opportunities and a wide range of potential outcomes.

We believe passive investing has a dual role to play in effective portfolio management. Passive strategies can be used to:

• Strategically provide long-term exposure to certain markets. We believe this can be particularly effective in more efficient markets and where investors are primarily concerned with goal achievement versus market outperformance.
• Temporarily gain exposure to certain markets in conjunction with portfolio rebalancing or account transition management. For example, while executing a tax-loss harvesting strategy, investors could replicate the investment characteristics of a sold security by temporarily buying an ETF with similar characteristics while waiting to make a final buy decision on a replacement security.

At Key Private Bank, our investment recommendations are based on objective analysis and research, not emotions or biases. Our approach may be summarized by stating that we believe in investing actively. We surround each client with a multi-disciplinary team of experienced professionals who use both active and passive investments in ways that make sense for their long-term strategy. Our clients deserve our team’s best thinking and all the benefits of Key Private Bank’s disciplined, time-tested approach.