The active versus passive debate* has led to numerous studies, detailed analysis and thought-provoking theories. Yet, in our view, trying to establish a winner is not the right approach. The data and time period selected, the asset class invested in and how success is defined make for an uneven playing field. What is clear is that passive funds have attracted significant inflows in the last decade and now play a major role, for better or worse, both in investor portfolios and in the functioning of global capital markets.
Academic studies and conclusions
Extensive academic studies have been undertaken into the benefits and limitations of each approach. While compelling arguments can be made for active and passive, there are certain findings that frequently recur. These are:
- The average active manager typically underperforms a passive benchmark after fees
- Some active managers are able to consistently outperform a passive benchmark after fees
- Certain markets and asset classes are harder to outperform in than others
- Outperforming active managers tend to manage portfolios with higher conviction positions*
These findings broadly ring true to us, but importantly with certain caveats. At Henderson, we firmly believe in the ongoing value of active management and its potential to help investors achieve their long-term objectives. To this end, our investment teams are given the autonomy to develop investment processes that allow them to identify and act upon opportunities discovered through detailed analysis and in-house research. While always subject to rigorous risk controls, this means, in most cases, taking meaningful positions away from index weightings. Certain teams, of course, have investment objectives that require an element of benchmark matching but the Henderson approach is predominantly built around active management.
We believe that active managers add value because:
- Through a selective approach they are able to identify innovative, well-managed companies and overweight what they believe to be the winners of tomorrow
- They can react to and anticipate shifting investment themes by altering sector and asset type weightings, performing more granular and dynamic allocations within the asset class
- When markets are challenging, they can avoid areas with deteriorating outlooks, helping to protect capital
A place for passive
We also recognise the value of passive investing. While we are not a provider of passive investment funds, some of our managers, particularly in the multi-asset space, use passive vehicles to help achieve their investment objectives. Passives provide a quick and cheap means of gaining exposure to an asset class and can prove an effective way of expressing market direction or asset allocation calls. The debate, in our view, should not be around whether one approach is better than the other but focus on when to use active or passive managers.
The key argument for passive is that it is cheaper. This is generally true but, as with many of the goods and services available to us, cheaper does not necessarily mean a better outcome for the end consumer. Indeed, a passive approach by its nature has limitations: a passive fund will not, on average, beat its benchmark after fees and in falling or volatile markets in particular, end investors are unlikely to be best served by an approach that simply replicates the market. In our view, it is when and how passive and active are used, and how they are blended, that will determine success.
Reshaping the investment landscape?
The growth of passive investing also raises questions about the impact on capital allocation and the efficiency of markets. Active investors currently allocate based on a variety of factors including where they see good or bad business practice, innovation, disciplined management of a company's finances and valuation. As such, they are the allocators and price setters of capital within a functioning economy. Without this price-setting mechanism, established companies could allow productivity to fall or corporate governance standards to slip without necessarily seeing a corresponding slump in their share price or access to capital.
Conversely, new businesses seeking to raise funds are likely to struggle to access capital in a passive-led market where securities are bought indiscriminately and larger companies receive the bulk of allocations. This trend would potentially stem overall economic growth levels and reduce the efficiency of markets. It may, however, also present opportunities for active managers able to capitalise on economic and inpidual company events based on their differentiated approach to security selection.
There are also social and ethical considerations around the growth of passive investing, with research increasingly highlighting the negative side-effects. These include the lack of corporate governance involved with passive allocations, with, for example, exchange traded funds (ETFs)* not being discerning when allocating to companies responsible for pollution and users of child labour. A recent research publication by a large bank suggested that capital allocation is more efficient in a command (Marxian) economy, where someone at least is actively taking decisions, than in an economy where capital allocation is entirely passive. There is also the question as to whether the pressure for ever lower fees for passive, coupled with the asset growth required to make providers' business models viable, raises suitability issues around the promotion of passive products to clients.
What should be expected from 'active' going forward?
What the active passive debate has importantly done is bring into focus what should be expected for the additional fees paid for active management. With increasingly sophisticated analytical tools available to all investors, assets are moving in ever greater quantities towards those active managers who set themselves apart in terms of risk-adjusted returns. This has already brought active share (which admittedly should be treated with care, see Henderson's guide Understanding active share) and the drawbacks of funds that closely track an index to the fore. Additionally, it can lead to active managers being asked to justify high cash positions and extends to the levels of education, client support and manager communication expected in return for an 'active' allocation.
It also raises the question as to what more will be expected of 'active' in the future? This could include issues around:
There is already increased appetite at a government level for investors to play a greater role in promoting long-term value creation within companies, as referenced in the UK Government's 'Kay review'. This trend could develop further, with investors expecting ever more involvement from their managers, potentially extending to private equity style participation and ever more demonstrable engagement.
With sustainable investing growing in popularity, active managers may see increased demand for Socially Responsible Investment (SRI)-style portfolios that reflect certain values. Millennials are increasingly attracted to brands that share their own ethical and social standpoint and flows may favour active managers that are aligned with these.
Active managers without a specific SRI mandate are also increasingly using Environmental, Social and Governance (ESG) criteria to assess opportunities. This more holistic approach helps drive outperformance, according to research from Deutsche Bank, HSBC and Harvard Business School, and is an important part of investing that is missed by many passive funds.
While early steps are being made to provide ETFs that screen out certain types of companies, applying filters mechanically relies on scoring by ESG ratings agencies. These scores are based on company disclosure and regularly miss the full depth of sustainability efforts, particularly in the case of small and medium-sized companies with less mature reporting capabilities. As a result, active managers will often use scores as an initial filter but base their investment decisions on actual engagement with companies.
Capital preservation and portfolio adjustment
The future may also see increased scrutiny of the suitability of passives for certain end investors. The returns generated by a passive investment depend entirely on the direction of the overall market, with moves often particularly steep at the start of a market correction. Active managers typically have the ability to alter their holdings within the portfolio in order to help protect or grow capital in volatile conditions. This may be deemed worth the additional cost for end investors who are uncomfortable making difficult timing calls
Proven active returns
Going forward, the bar will also likely be set much higher for active managers to prove the value they provide to end investors and how this justifies the fees charged. This is likely to lead to more detailed performance comparisons against passive, semi-passive and active competitors. It may also lead to comparisons of the additional services provided to end investors that are covered by this fee. For value to be measured fairly, the emphasis will be on active managers to explain very clearly at the outset what the product is designed to deliver.
The means of accessing active managers may also change with certain active funds now being made available within an ETF wrapper. This is potentially a positive for investors and active fund providers alike with improved accessibility, transparency and increased liquidity.
Since 2009 financial markets have trended upwards, providing a particularly supportive backdrop for passive investing. When markets suffer a severe or prolonged correction, the limitation of cheap exposure to these markets is likely to become more apparent. What is clear is that in taking an active, passive or blended approach, selectivity will remain key for investors, with product providers expected to deliver genuine value for money and superior client service.
Active - An active approach involves investing in a fund where the fund manager actively takes decisions about which and what proportion of investments to hold, often with a goal of outperforming a specific index. This relies on a manager's investment skill.
Active share - This measures how much a portfolio's holdings differ from its benchmark holdings. For example, a portfolio with an active share of 60% indicates that 60% of its holdings differ from its benchmark, while the remaining 40% mirror the benchmark. Please see our guide Understanding active share
Exchange Traded Fund - A marketable security that tracks an index, a commodity, bonds, or a basket of assets. ETFs trade like a common stock on a stock exchange and experience price changes as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than actively managed mutual funds.
Higher conviction positions - positions taken within a portfolio that are significantly away from the benchmark weighting
Passive - A purely passive approach invests in a fund that tracks an index. It is called passive because the fund simply seeks to replicate the index. Many Exchange Traded Funds are passive funds.
For explanations of any of the technical terms included in this article, please refer to the Janus Henderson Glossary.