When does passive investing make sense?

Wouldn’t life be easy if investing was a simple numbers game?

The theory of investing by tracking an index or a range of indices appears to make perfect sense.  After all, active managers produce a wide dispersion of returns and many - after costs - have often lagged indices’ performance.

So why not simplify things: remove manager risk and invest ‘passively’ by owning a fund that simply replicates an index?

Sadly, it isn’t that simple.  There are probably as many scenarios when an actively managed portfolio will deliver a better outcome than a passively managed one, even if the actively managed one underperforms its index-based benchmark.

How could this be the case?

Allocating assets is an active decision

If a single asset class could solely meet an investment objective, then buying an index-tracking fund could make sense.  However, it is rarely appropriate for clients seeking long-term returns to have exposure to just one asset class.  Assets are typically blended together to achieve a risk/return profile that ensures a portfolio is aligned with the client’s objectives. Critically, choosing which assets to include in a portfolio and how much is assigned to each, will likely have a significantly greater impact on performance than the return of each asset class, relative to the relevant index return.

The true worth of any passive or active manager should be measured at the total portfolio level, after the impact of strategy, tactics, stock selection and all costs. Individual elements might not always add value after costs relative to an index – and quite possibly at the portfolio level, against an index of blended indices. However, the overall result is what actually matters, relative to what other managers have achieved.

Any manager that produces top quartile returns over the long term – regardless of whether the results have been achieved actively or passively – deserves consideration.

Measuring portfolio managers against their ability to match index returns for an individual asset class is insufficient:  the way in which they blend assets together will matter much more.

So, the ‘active’ decision about which index you adopt could lead to a worse result than selecting an active manager who mildly underperforms a better index that produces a greater return.

Some asset classes are ‘un-trackable’ via an index and require active investment decisions regardless Examples include infrastructure, renewable energy, private equity, private debt, physical property and hedge funds. Adding these types of investments to a diversified multi-asset portfolio can help reduce overall portfolio risk and/or enhance returns.

The ethical consideration

Ethical exclusions and stewardship practices also need to be considered when considering an active or passive approach. While it is possible to find or design passive strategies that meet ethical criteria, these funds are often significantly more expensive than their ‘non-ethical’ equivalents, as passive managers are not able to exploit economies of scale to the same extent as active managers.

Integrating broader ESG or sustainable investing criteria is not very practical using passive indexes.

While passive managers offer a variety of ‘ESG-aligned’ indices, these are reliant on an approach that give every company an ESG score on a variety of quantitative metrics. There is little correlation across providers on what represents a ‘good’ company. Much like ethical or other customised funds (such as those that hedge currencies), these are again often sold at a much higher fee to the headline index.

Similarly, while passive DFMs can theoretically engage with company management and exercise their shareholder votes, in practice, the managers of passive funds – with their focus on minimising costs – tend to have disproportionately small teams focused on this element of company ownership. There is also reason to doubt whether company boards truly listen to investors who, by their nature, will never actively buy or sell their shares in response to changes the company does or doesn’t make.

Consider market distortion

We should also consider the value of independent active managers in their role as price setters in markets. We believe this is probably misunderstood and undervalued.  The whole world cannot buy index trackers, and markets are, arguably, already becoming distorted with individual companies being inappropriately valued by their huge influence.

There is evidence to suggest that the rise of index tracking has pushed up the values of the largest companies relative to many smaller companies which aren’t included in the indices they track.

There is often a disproportionate sale of smaller companies each time an investor goes passive.

A nuanced decision for investment success

We understand the appeal of low-cost and seemingly low-risk passive investments.  However, a more thorough analysis into the difficulties of implementing such an approach successfully makes it a much harder and more nuanced decision.

The best active DFMs try to help underlying holders achieve much more than just stock-picking their way to outperforming benchmarks and indices. Ultimately, a client is using a multi-asset active manager for their strategic and tactical asset allocation services, including access to the full range of investment opportunities.

While it would be nice to think that the majority of active managers could outperform indices after costs consistently, this has never – and is unlikely ever – to be the case.  However, this doesn’t mean that the overall results active managers achieve won’t be better, after costs, than many passive alternatives.