Mark Paccione, CFA, CFP®
Director | CAPTRUST Consulting Research Group
Senior Manager | CAPTRUST Consulting Research Group
Yankees and Red Sox, Duke and North Carolina, the Beatles and the Rolling Stones—all great long-term rivalries. The ongoing debate about the relative merits of active versus passive investment management seems just as long and contentious. While both approaches have their strengths and weaknesses, we at CAPTRUST believe you can root for both sides. The debate over one versus the other is misguided; a more thoughtful, alternative approach to active and passive investment management merits consideration.
The active-passive rivalry has intensified in recent years largely because of two factors: low-cost passively managed investment product proliferation and actively managed equity fund underperformance. Passive funds, especially in certain asset classes, are substantially less expensive than their actively managed counterparts. In most industries, low cost is a competitive force and a strategic choice. This is also true in investing where the price paid significantly influences future returns. It is, therefore, no surprise that investment managers have expanded their passive product sets to provide low-cost ways to invest in a broad array of markets, including U.S. and international equities and fixed income. Investors can now implement passive investments for more asset classes, allowing passive funds to compete for a larger portion of overall portfolio assets.
From a performance perspective, passive investing gained momentum due to headline-grabbing active equity underperformance. Since the 2008 financial crisis, macroeconomic factors have dominated the investment landscape with central bank actions such as the U.S. Federal Reserve’s quantitative easing program driving market moves and beguiling traditional active management tools. This created an environment where many stocks moved together, reacting to one macroeconomic development after another. Many active U.S. and international stock managers have struggled to outperform their respective benchmarks in this highly correlated environment. The statistics speak for themselves; over the past five years, the S&P 500 Index outperformed 71 percent of U.S. large-cap blend managers, and the MSCI EAFE Index outperformed 68 percent of foreign large-cap blend managers.1 Given lower costs and underperformance in two highly visible asset classes, passive management now challenges traditional active management for future investment dollars.
Does this mean that active management does not have a portfolio role to play? Our view is that it should. Active management possesses a number of advantages over passive in certain circumstances, making it a useful tool for investors seeking better investment outcomes. We prefer active over passive when overall market exposure, as defined by a benchmark, is undesirable. The most obvious current example is U.S. fixed income. Today, the U.S. bond market contains more Treasurys than it did before the financial crisis due to the Fed’s bond buying program and other stimulus measures. Broad fixed income indices such as the Barclays U.S. Aggregate Bond Index, in turn, reflect Treasurys’ growing market share. While passive bond funds can provide low-cost exposure to the market index, investors may not want to own a disproportionate share of Treasurys. Active funds provide investors with a compelling way to alleviate this problem in ways that may also potentially insulate their portfolios from index interest rate risk. In addition, unlike equity managers, active U.S. fixed income managers have outperformed since the financial crisis. In fact, 83 percent of active bond managers have outperformed the index and passive funds over the past five years.2
Investors can also use active management to refine their exposures to certain asset classes in ways that may help produce better outcomes. For example, a conservative investor may want growth but with less risk than the stock market. In this situation, a low volatility U.S. stock manager who employs a strategy that tends to lag the
broad market during longer periods of market strength but protects amid market stress may be more appropriate—even though the manager may underperform the broad market. This is because the variability in the manager’s returns will likely be lower than the market’s, which by definition yields a lower range of outcomes than an index fund may experience.
We also use active managers in asset classes where passive options do not exist or implementation cost is high, perhaps approaching active management expense levels. There are a number of alternative strategies where no passive options exist. For example, reinsurance, where investors assume insurance risks and collect premiums, is an exciting opportunity only accessible via an active manager. Investors who limit their portfolios to passive management will miss these investment opportunities. In other asset classes like high yield bonds or emerging market equity, passive investment costs approach active management levels, eliminating most or all of the low-cost benefit.
Given these factors, rather than choose sides between passive and active managers, CAPTRUST utilizes both active and passive investment management in its discretionary model portfolios, consciously deciding which strategy best fulfills a given asset class. We consider the specific investment mandate first. For capital preservation portfolios invested beyond money markets and certificates of deposit, we predominantly utilize active fixed income as bond managers have been more successful outperforming their benchmarks and can utilize tools to combat rising interest rates. For growth-seeking discretionary portfolios tilted more toward stocks and other traditionally risky asset classes, we place greater emphasis on performance relative to an index. Given active stock managers’ previously noted struggles, we have tended to delegate a greater portion of discretionary growth portfolios to passive vehicles in recent years.
Additionally, CAPTRUST considers expected market conditions and the particular asset class when deciding between active and passive investment options in discretionary model portfolios. For example, high yield funds invest in below-investment-grade corporate bonds and often in firms with some degree of bankruptcy risk. In an asset class where bankruptcy—and by implication permanent capital loss—is a significant possibility, CAPTRUST relies on seasoned active managers to perform the necessary credit analysis in selecting the individual securities.
Finally, CAPTRUST considers an active manager’s portfolio and investment advantage over the relevant index. If an active manager positions its portfolio to take advantage of a specific opportunity or express a specific theme, such as a European economic recovery, CAPTRUST may add the manager to discretionary portfolios in order to take advantage of the opportunity.
While most sports fans root for only one side of a rivalry, the decision to use active or passive management is not a mutually exclusive choice. By defining the portfolio’s purpose, assessing market conditions, and evaluating the particular investment opportunity, investors can use both approaches to build toward successful investment outcomes.
1 Zepher, Morningstar