Active vs passive investments

September 1, 2017

In early 2008, celebrated investor Warren Buffet wagered $1 million that over a ten year period an S&P 500 index fund would outperform a portfolio of hedge funds carefully constructed by Protégé Partners’, Ted Seides. With just months remaining before the bet concludes, it’s all but certain that Buffet will emerge victorious. While the merits of both active and passive investing have long been debated in academic and professional circles, in recent times passive investments seem to have gained the upper hand, with active investment managers facing increasing scrutiny from their investors.

Active and passive investments represent two contrasting approaches to investing. Active investors look to apply insights gained from experience and research to select investments that will outperform the market. Passive investors on the other hand simply seek to achieve the same return as some theoretical benchmark portfolio such as the S&P500. To replicate these indexes, investors simply need to buy the same stocks in the same magnitudes as the index whose holdings are based purely on the criteria, such as market capitalisation, profitability, or momentum.

The case for passive investments

It wasn’t long ago that the burden of proof was on passive managers to demonstrate their worth but now it seems the tables have turned. According to Morningstar, 2016 saw over $250 billion flow into index funds and exchange traded funds. In the first seven months of 2017 another $391 billion had been poured into ETFs alone.

When courting multimillion dollar allocations from investors, prominent passive investment managers like Vanguard Investments and BlackRock call on a concept that can be found in any university finance textbook, the Efficient Market Hypothesis (EMH). The theory was made famous by academic Eugene Fama in the 1960’s and put simply, states that all stock prices instantaneously incorporate all relevant information and therefore reflect the fair value of the stock. Therefore, according to supporters of EMH, in the long run there is no way to obtain returns greater than that of the market on a risk adjusted basis making active investment redundant. Even assuming a weaker level of efficiency, the high level of competition amongst active managers could mean that any inefficiency in stock prices would quickly be corrected and therefore difficult to capitalise on in a consistent manner.

Investors who choose to allocate money to passive investments often cite the low fee structure as important to their decision. Without the need for dedicated research teams, passive managers are able to cut operational costs and offer fees substantially lower than active managers. In Australia for instance, the average fee for active equity funds is 1.37% per annum while indexed-linked funds sit around 0.91%, with ETFs even lower at 0.33% according to Morningstar. Therefore, even with the assumption that markets are not entirely efficient and managers can beat the market return, any returns that active managers achieve in excess to the market would be quickly eaten up by fees.

The manner in which passive investors construct their portfolio can be seen as both an advantage and a shortcoming. The formulaic approach taken by passive investors in constructing a portfolio provides greater transparency with the exact details of its construction freely available. By contrast, active investors allocations are the result of months of research and are therefore often closely guarded secrets. The need for passive investors to periodically rebalance the portfolio however, introduces the issue of tracking difference. Tracking difference is the difference between a product’s performance and the performance of its benchmark. While the benchmark index is rebalanced instantaneously and without transaction costs, this is not the case for the products tracking them. Although these additional costs can cause passive products to underperform their benchmark, this difference is mostly insignificant.

The case for active investments

Over the same period in which passive investing is seeing significant increases in assets under management, active investment managers have suffered large outflows. Despite this, many maintain there is still a place for active investments.

Proponents of active investments believe that when comparing the two investment styles, it is largely a case of you get what you pay for. In particular, passive investments have no concept of risk management. While active managers can plan for the future and take measures to protect against certain events, passive managers cannot. For example, by construction many passive Australian Equity products are significantly invested in financials and resources. While this can be advantageous when these sectors are performing strongly, the results for investors could be disastrous if both sectors collapse.

Others still suggest that the trend toward passive investments is being driven by the current economic environment. The low interest rate environment brought on by the Global Financial Crisis in 2008 is thought by some to contribute to the lacklustre results of active managers. Moreover, the bull market, which has just entered its eighth year, is thought to favour passive investors, with active managers often being too conservative during these times. With the global economy kicking back into gear and interest rates on the rise, active investments might yet prove their worth.

With so many variables involved it is unlikely that the debate over the merits of active and passive investing will ever be settled. In the short term however, it is clear that if active managers don’t begin to deliver their promised returns, investors will continue to turn toward passive investments in droves.

The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.