Investments - Strategy

Active Or Passive Investing? Two Principles Provide the Answer

This article was originally published on Forbes

November 8, 2016

A recent series of press articles have generated renewed interest in the “active versus passive” portfolio management debate. Given the recent underperformance by active managers, it certainly makes sense to examine this dilemma yet again. Whenever many active portfolio managers fail to beat the S&P 500, investors’ frustration peaks, and it is tempting to switch to passive management. But is the decision that simple? I don’t think so.

Some aspects of investing involve alchemy rather than chemistry. The famed Cal Tech physicist Richard Feynman once said “Think how much harder physics would be if electrons had feelings!” Sometimes investing is more like studying electrons that indeed do have feelings, and trying to figure out how those feelings might factor into predicting future results.

Whenever I analyze investment matters, I always try to remember that human behavior factors into market dynamics in varying degrees. This is particularly true when deliberating on the active or passive choice, and I believe a skilled manager needs to recognize the variable degree to which these behavioral factors play a role.

Behavioral analysis tools are much less accessible than raw, quantitative data. Much of the recent active/passive analysis addresses vast compilations of historical data—returns, standard deviations, quartile rankings, etc. Such data make a great sandbox for quantitative analysts’ play, and can sometimes lead to insightful projections. While it’s helpful in explaining how active styles have fared in the past, it fails to recommend a solid choice between passive or active management going forward.

Throughout this timeless debate, many companies are successful offering either (or both) active or passive management, suggesting that there are strong believers in using both approaches despite the inherent ambiguity. This demonstrates how difficult it is to state basic laws or principals regarding active versus passive management. For example, even the basic direct relationship of risk and reward can be violated for extended periods of time.

Many other investment rules of thumb have failed the consistency test. In fact, I think it is very difficult to propose general investment principals that are durable throughout all market conditions. This thought led me to ponder if there indeed are any permanent investment rules. To borrow from Professor Feynman’s analogy, if electrons had feelings, are there any absolute observations we can make?  In thinking about the eternal dilemma of whether active or passive, I believe it’s possible to state two general principles that hold throughout all market conditions. I propose the following two investment beliefs that are applicable to understanding the active versus passive role:

Principle One: Capital market efficiencies vary across asset classes

The availability of investment information varies from market to market. An “active” management approach for less efficient asset classes offers a greater opportunity to outperform the market, while a “passive” investment approach may be more appropriate for highly-efficient asset classes. In other words, there are arguments to be made for utilizing both active and passive strategies when formulating an overall portfolio.

For example, U.S. large cap equities are well covered by Wall Street analysts, making it difficult to identify undervalued companies. For this highly-efficient asset class, a passive investment approach may be appropriate in some instances and can be more cost effective. On the other hand, emerging market stocks are generally under-researched and harder to evaluate, offering more opportunities for an active manager to identify mispriced companies. The key here is to recognize the differences and then make the right choices.

Principle Two: Capital market efficiencies can vary within asset classes

Within almost every asset class, active versus passive management styles can periodically swap places as winners. Even asset classes considered the most efficient can sometimes benefit from active management over passive. The reason is quite different than that given in Principle One. Principle Two relates to something called the “Grossman-Stiglitz Paradox” that I have written about elsewhere: If markets are perfectly efficient, then there is no reason to research them, yet markets can only remain perfectly efficient as long as they are continuously researched. When investors lose patience researching stocks in a highly efficient market, passive investing appears attractive, which in turn opens up opportunities for active research again. This can result in a cycle of active/passive trends over the years.

There are subtle but important distinctions between the two principles. Whereas principle one addresses variations in market efficiency across asset classes, principle two addresses variations in market efficiency within an individual asset class. Note also that principle one usually concerns the classic case of under-researched asset classes, which implies that, as the asset class becomes more popular, it may attract more researchers, and hence become more efficient. Principle two can apply to all asset classes as the degree of efficiency changes.

I think these two principles can help guide decisions about choosing an active versus passive approach. I can usually categorize each asset class by determining where it is located along the spectrum of efficiency/inefficiency. The cycles have rather long lifetimes and recognizing transitions early can be challenging.

As we approach the end of 2016, it is important to check on the current efficiency status in the capital markets. Passive indexing and exchange-traded fund investing have worked very well in the past years, prompting the revisiting of this ageless debate. However, as the Fed begins to normalize rates I’m expecting more market volatility, and passive strategies alone may not necessarily work over the next years.

Investors trying to achieve a long-term return goal will need to embrace both active and passive strategies, while developing tools to discern the capital market efficiency differences along the way.

Disclosure: The general nature of this article has not been tailored to any particular investor’s need. The opinion of the author is as of the date of this article and subject to change.

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