Active Versus Passive Investment Management: A Different Take

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Nov 24, 2017 11:00:00 AM

and tagged Investing

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active versus passive investment managementOne of the major issues in the financial world is active versus passive investment management. The terms themselves are a bit of inside baseball, but it might help to think of them like this: Active managers say they are smart enough to beat the market and try to do so. Passive managers, on the other hand, say no one can beat the market and so just own it.

In this debate, I am in the middle. I certainly see how active managers can add value. I have my own personal set of active strategies that I use, so I get and believe the active manager story. Here at Commonwealth, we work with a great selection of active managers, and they do a good job of adding value. At the same time, it is not easy—and not everyone who claims to be adding value is. (As always, do your homework.)

The problem with passive investing

The active versus passive split makes sense and is relatively easy to understand. What is a bit tougher to understand—and deserves more thought than it gets—is passive investing on its own. Passive investing is usually expressed as buying the whole market. In practice, this means buying all of the securities in an index in the weights that compose that index. For the S&P 500, for example, you would buy all 500 stocks in the weights they have in that index. Going forward, your returns would be the same as the index, less any costs. You would not beat the market, nor would you trail by more than the expenses.

The problem is that the gap between theory and practice can be wide. Consider matching the weights of the different securities in the index. This is not a problem—when you buy in. But what about when prices change the next day? When do you rebalance to keep the weights matched? What about when dividends or coupon payments are made? How do you put new money in? How and when do you invest it? As you can see, there is a lot of action under the surface of a “passive” management strategy.

Things get even harder when you move into illiquid markets. There, securities that make up the index may simply not be available at quoted prices. Many fixed income markets are like this. What securities are included? Why? What effect will that have? Why?

Active decision making

Even if we match the index perfectly and keep it matched, we still have not exorcised the fact of active decision making. Which index is best? What biases and assumptions are baked into it? As an example, the Dow Jones Industrial Average is price weighted, so stocks with a higher price have a higher weight. A stock at $100, for example, would have 10 times the weight of a stock at $10, even if the $10 stock were a much larger and more important company. You can see, for example, how a stock split could have an effect on weightings. In practice, adjustments are made, but this method of weighting is still rather arbitrary.

The S&P 500, on the other hand, is weighted by market capitalization (i.e., how much the whole company is worth). This makes sense, in that more successful companies should be worth more and be weighted more heavily. But the effect is that investors in this index are most exposed to stocks that have the greatest run up. In the lingo, this is a growth bias, where the index is more exposed to growth stocks. This is a perfectly valid approach, but it is one more often associated with active managers, who choose that style, than with passive investing.

Other forms of the S&P 500 weight the stocks differently (e.g., using equal weights). Again, this is a reasonable approach. Compared with the cap-weighted index, however, this would overweight smaller and less valuable companies. It would also introduce what is known as a value tilt, with more exposure to value stocks. Again, this is a legitimate strategy, but one that has more than a taste of an active management decision.

When you dig into the details, passive is not quite so passive and necessarily involves a number of active decisions. Further, passive is often seen as the easier approach. To properly use it, however, requires just as much thought as selecting active managers.

Keep aware of biases

Another key point here is that when you compare your portfolio with the index, you should keep biases in mind. If you have a conservative portfolio, for example, comparing it with the S&P 500 (with its growth bias) can be misleading. In a strong market, you should be underperforming that index! Knowing your benchmark indices, as well as what they are showing, is critical to really understanding how you are doing.

These are all things to keep in mind when looking at your portfolio, however you choose to manage it.

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Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

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