A Brief Overview of Active and Passive Investing

Once you've identified a robust asset allocation strategy that has a high probability of achieving your long term return goals, you have to implement it via the investments you choose for your portfolio.

At this point, the most important question you have to answer is whether you are going to take an active or a passive approach to investing. In a nutshell, the active investor believes that he or she can consistently generate (or choose fund managers who can generate) returns that are above the returns generated by some benchmark portfolio. In contrast, the passive investor wants only to match those benchmark returns at the lowest possible cost.

In fact,
we wrote a book about the arguments on either side of the active versus passive question.

While different studies cover different periods and different managers, virtually all of them find that a majority of active managers usually fail to beat their benchmarks in any given year. This percentage only grows as the performance measurement period increases (e.g., to five, ten, and twenty years). We believe that five factors account for most of the dismal track record of many active managers.

First, accurate forecasting is extremely challenging because economies and financial markets are complex adaptive systems, filled with positive feedback loops and non-linear effects caused by the interaction of competing strategies (for example, value, momentum, and passive approaches), and underlying investor decisions that are made by people with imperfect information and limited cognitive capacities, who are often pressed for time, affected by emotions and subject to the influence of others.

Second, portfolio constraints often mean that accurate forecasts are not fully translated into portfolio positions (e.g., U.S. mutual funds have traditionally been prevented from taking short positions).

Third, consistently accurate forecasting must be based on some combination of superior information and/or a superior model for making sense of it. Yet history shows that these advantages are eventually undermined, whether by changes in regulations (e.g., Regulation FD in the United States, which limited preferential analyst access to companies), changes in the underlying economy and/or investor behavior (that undermine a model's assumptions or weaken the advantage provided by a previously superior type of information), or by competitor copying (as has happened with "crowded" hedge fund strategies that drove down returns, or via replication by cheaper and faster algorithms).

Fourth, successful active funds usually accept new fund inflows (since this boosts manager compensation based on a percentage of assets under management), even though this leads to lower returns (since it is comparatively much easier to identify smaller versus larger opportunities to make profitable investments).

Finally, a significant portion of the gross alpha (returns above the benchmark index) generated by actively managed funds is usually lost due to their higher expenses and greater tax liability generated by their higher trading volumes.

When you add up all these arguments, it should come as no surprise that a lot of people have chosen to use passive funds that track broadly defined asset class indexes rather than active managers to implement their asset allocation strategy.

On the other hand, experience has taught us not to be ideologues in this active versus passive debate. There are four important exceptions to our general rule that, for investors with a long time horizon, passive investing makes the most sense.

The first exception is that, over the course of an investing lifetime, almost everyone will come into possession of superior private (which is different from illegal) information, that creates the opportunity for an active management success. For example, an investor may be aware of different developments in her industry that lead her to conclude that the market as a whole is underestimating its future growth rate, which should soon accelerate. In this case, she might allocate a portion of her portfolio to an exchange traded fund that tracks the industry, and watch its returns outperform the overall market index over the next year. Of course, this also raises the point that successful active management also requires knowing when to sell, realize one's profits, and reinvest them back into index funds.

In essence, two forecasts are involved: one that says it is time to buy, and one that says it is time to sell. Active opportunities like the one just described don't happen very often for most people. In addition, if your superior information is limited to developments at your own company about which the public is unaware, you run the risk of committing the crime of insider trading if you trade your company's shares rather than a broader ETF.

The second exception is one we have frequently written about: bubbles, or, more technically, situations in which one or more asset classes appear extremely overvalued. When these situations occur, and when the asset class in question is well above its target weight in your portfolio, prudent risk management demands that you make an active management decision to reduce your allocation to well-below its target weight. The purpose of our Asset Class Valuation and Macro Update features is to help investors make these decisions.

The third exception to our preference for passive investing in broadly defined index products is an asset class (e.g., timber, or, in some regions, foreign currency bonds) where no indexed investment vehicle is yet available, or where current indexing methodologies are questionable (as we have noted in our writing, the use of market capitalization weighted indexes to track the performance of bond markets is arguably an example of this).

The fourth exception is the most challenging. We all know that in hindsight, it is possible to identify active managers who have outperformed a comparable index fund. But to be confident that this reflects skill and not just luck requires either a long track record of outperforming and index fund by a modest amount, or a shorter record of outperforming it by a substantial amount.

In practice, this degree of statistical confidence about the existence of manager is very rare; that is what makes people like Warren Buffett so special. However, it is one thing to identify Warren Buffett with the benefit of hindsight; it is far more difficult to identify the next Warren Buffett. Hindsight is not foresight, and study after study has found that past performance is usually not a good predictor of future performance.

Under these difficult circumstances, people who believe they have identified a truly skilled active manager usually use some variation of the "four Ps" to reach a conclusion about whether said manager will continue to outperform a comparable index fund in the future. They assess the quality of the manager's People; the logic and clarity of the manager's investment Process; the extent to which it is consistently reflected in the composition of the manager's Portfolio; and whether that portfolio has delivered superior Performance in the past.

However, we use one additional criterion to further narrow the list of actively managed funds in which we would consider investing: We prefer only those actively managed funds whose objective is to deliver returns that are uncorrelated with the returns on broadly defined asset class index funds.

Technically, these are funds are said to use "uncorrelated alpha strategies." In contrast, traditional actively managed funds deliver a mix of overall asset class returns (technically known as "beta") and alpha. However, an investor can obtain the asset class returns more cheaply by buying an index fund. He or she should only pay higher fees for returns that are not only above those on index funds, but also uncorrelated with them (because such returns add the most diversification benefit to a portfolio).

We include uncorrelated alpha strategies in some of our model portfolios for two reasons. First, because we believe that successful active management, while rare, is possible. And second, because of the undeniable mathematical benefits of 
uncorrelated alpha to a portfolio, in terms of its ability to reduce the risk required to achieve higher long-term real return targets.

That said, the relatively low maximum limits we set on uncorrelated alpha strategies (e.g., equity market neutral and global macro) reflects our recognition of the difficult challenges involved in consistently delivering it over long periods of time, as does our focus on minimizing fund costs (note that the mutual funds we use cost a lot less than "2 and 20" hedge funds), and our recommendation that these funds be held in tax-advantaged accounts because of the extensive trading they often undertake.

Clearly, we are trying to make a tradeoff here, and reasonable people can disagree about the maximum amount we are willing to allocate to uncorrelated alpha strategies. That said, we believe the underlying logic of our argument is sound, and in the case of higher portfolio real return targets, some allocation to uncorrelated alpha strategies makes sense from a risk/return perspective.

In sum, we are pragmatists, not rigid ideologues in the active versus passive investing debate. Our objective is to highlight how each approach can best be used by an investor to achieve his or her long term goals.

Now let’s move on to another interesting issue: why passive investing and index investing aren’t always the same thing.

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