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Another Stroll Around The "Active" Vs "Passive" Investment Debate

Jeanette Garretty and Stuart Katz, May 29, 2020


This article jumps into the ever-present debate about the right way to think about the benefits/costs of actively trying to outperform a market, or capturing its upside without spending on fees to achieve index-beating returns.

The age-old debate about the pros and cons of “active” versus “passive” investing got a new jolt when global equity markets slumped earlier this year – and then recovered somewhat on the back of massive central bank quantitative easing. (We will see how long this recovery might last, given some grim economic data.)

The problem with these terms, of course, is that they can be misleading. Even the most “passive” investor is taking a decision of some kind, if only to capture market “Beta” rather than try and be cleverer than the other guy by picking undervalued stocks or predicting if a security is going to fall before others do. “Passive” entities such as exchange traded funds can be used to build portfolios where an active strategy is involved. We have had the phenomenon of “Smart Beta”, aka factor-based investing, and so forth. 

The conversation goes on because, at root, this is about the added-value proposition of investment management. And it speaks to how wealth management is also about deciding how to handle risk, given that no-one is omniscient, has perfect information about what drives markets, or will be able to reliably time markets. Add in, of course, the commercial vested interests driving what sort of funds are pushed in front of advisors and clients, and it is easy to see why debate rolls on. 

To discuss some of these ideas are Jeanette Garretty, chief economist and Stuart Katz, chief investment officer, at Robertson Stephens Wealth Management. The editors here are pleased to share these ideas; the usual disclaimers apply. Jump into the debate and email tom.burroughes@wealthbriefing.com or jackie.bennion@clearviewpublishing.com

No question about investing is likely to lead to fisticuffs faster than the question of the relative merits of active and passive investments. It is not without reason that the debate has taken on the fervor of religious arguments, as people have come to think of themselves as having innate qualities as active or passive investors. Lost in the conflict is a focus on the actual reason why there are both active and passive investments, and why, at different times and for different purposes, both types of investments make sense. In general, when companies are operating in a stable, well-understood economic environment and company financial information is widely accessible, an active manager may not add much in the way of differential (positive) performance. It is for this reason that there are a number of widely utilized passive investments for US large cap stocks. However, for investments in industries or sectors defined by innovation and disruption and lack of transparency – technology, healthcare, small cap, emerging markets, non-investment grade credit, to name a few – an active manager may be the best way to find opportunities and pursue investment themes such as digital infrastructure. 

Furthermore, an active manager implements bottom up fundamental research and judgement to select and weight quality business models at attractive valuations. This contrasts with passive funds that employ “top down” formulas. This flexibility can lead to a fund that over time demonstrates significant “downside capture”, i.e. capturing less of the downturn in the overall market when times are bad while obtaining most of the upside of rising markets. Therefore, active management can be an important part of the defense for a portfolio, even though invested in so-called risk assets such as equities.

The challenge, of course, is in deploying active and passive investments effectively to achieve the overarching goal of the financial plan. Portfolio construction without a plan is similar to getting into a car without knowing your destination. A careful evaluation of any manager, includes strategy, process, fees, and tax efficiency, with passive investments requiring special attention to the sometimes minute but important differences in composition and leverage that can easily be overlooked. The lack of experience, skills, process and time to focus on active manager selection often leads to a default passive only solution.

Today – May 2020 – no one would describe the economic environment as “stable and well-understood.” It seems that each week, we witness another unprecedented development including most recently employers cutting a monthly record 20.5 million jobs in April and joblessness standing at 14.7 per cent, the worse level since the Great Depression. As we begin to think of opening up the economy, we begin to absorb that the recovery, like all recoveries, will be distinguished by its wide variety of winners and losers - with the added appreciation that being a “loser” in this recovery may mean going away, not just falling behind. Companies with strong balance sheets and management teams and exceptional products before the ravages of the pandemic will be the better prepared to survive and thrive. Unlike the expansion that inevitably follows, a recovery is not a wave to be surfed, a tide lifting all boats. A recovery is a hair-raising whitewater excursion, with Class 4 rapids. The right guide, the one who knows the river inside-and-out, is a treasure.

Having a fundamental view is critical, because economies, asset classes, industries, companies, and securities are experiencing unprecedented cross currents. Identifying the required margin of safety to protect and grow a client’s investment portfolio requires acumen and discipline in an environment where long-term growth and attractive income will be difficult to achieve. Currently, equity and credit markets seem to be anticipating different recovery timelines although there is often cross contamination of fear and greed between these markets creating dramatic and unpredictable levels of volatility. Volatility is an opportunity for investors with thoughtfully constructed portfolios.

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