For 40 years, there has been a fierce debate about the best way to invest. Is active management best or passive? Should you try to beat the market or just match it? Academic theory has been weighed against practical evidence. In fact, the answer depends on your investment preferences and cannot be reduced to performance.
In the arcane world of investing, a heated debate has been simmering for almost 40 years over what is the best way to invest. ‘Active’ or ‘passive’? While the debate is technical, and at times academic, it can significantly affect to what extent you as an investor may attain your objectives.
Originally, investments were always actively managed. Portfolio managers sought to buy the equities or bonds they judged most likely to outperform the rest of their markets. But then academic research started to suggest that it was virtually impossible to outperform consistently. So, investment funds started to be launched that aimed simply to perform in line with a chosen market index.
The nub of the active / passive debate is the issue of performance, although this is not the only issue. Do active or passive funds perform best? There appear to be some exceptional portfolio managers of active funds who more than hold their own over long periods of time. But, on average, the evidence suggests that in many categories passive funds do best.
Even so, there is more to investment than simply performance. As your goals grow more complex, you may want to make investments that have for example a specific social or environmental impact. Actively managed funds have greater flexibility, and so are more likely to match such requirements.
Defining active and passive
So, in practical terms, what is active management and what is passive? Broadly speaking, the portfolio managers of active funds seek to outperform the returns of a specific benchmark. The manager of a European equity fund, for example, might seek to beat the MSCI Europe Index, which tracks the performance of equities in 15 countries in Europe. Or a hedge fund might look to outperform a cash index such as 3-month Libor (London Interbank Offered Rate).
Passive investors, on the other hand, accept the market return by simply tracking a market index. Passive funds normally take the form of index funds or exchange-traded funds (ETFs). They are low cost because their portfolios are automatically rebalanced and so there is no need for a portfolio manager or any investment research.
The heart of the matter: Markowitz and Buffet
The theoretical justification for passive investing has academic support. At the heart of this is Modern Portfolio Theory (MPT). Developed by financial economist Harry Markowitz in the 1950s, MPT asserts that the relationship between risk and return can be quantified, and that active management is fruitless because markets efficiently price in all information.
Yet experience has proved this is not always the case. Perhaps most famously, Warren Buffet, the celebrated US value investor, has beaten the US equity markets for more than 50 years through his distinctive style of investing in high quality businesses such as Coca-Cola at the right price. Between 1965 and 2017, the compounded annual gain of shares in Buffet’s Berkshire Hathaway vehicle was 20.9% - far more than the 9.9% return (with dividends reinvested) for the US S&P 500 Index (Berkshire Hathaway 2017 annual report). Of course, it is difficult to spot investors of Mr Buffet’s class and many active investors simply do not beat the index in the long term.
ETFs and index funds are rapidly gaining popularity. In 2016, passively-managed funds accounted for just under a fifth (16%) of the asset management industry, according to a report from PwC, the consultancy. By 2025, this number is forecast to increase to a quarter (25%).
For and against
But there are reasons for and against both active and passive.
There are three main reasons in favour of actively managed funds:
- They have the freedom to outperform the market
- They have the flexibility to accommodate your specific wishes, such as investing sustainably
- They can dynamically manage risk by, for example, cutting exposure to more volatile sectors at times when equity markets look likely to fall.
There are three main reasons for passive funds:
- They are unlikely to materially underperform the chosen benchmark index
- Their fees tend to be lower than those of actively-managed funds
- In the case of ETFs, they offer a quick and easy way to buy market exposure.
Complementing each other
When the arguments for and against active and passive investing are weighed up, neither appears simply better than the other. The answer to the active or passive question is; it depends. Indeed, some investors choose to use passive investments as a core for their portfolio while investing in active funds at the periphery. This gives them exposure to the market but the chance to outperform and have greater flexibility at the margin. Other investors, however, choose actively managed funds as core because they are set up for the longer term and give the manager the time to outperform. In this case, exchange-traded funds (ETFs) might be used for satellite exposure that are designed in a more tactical, short-term way.
After 40 years of debate, it appears that passive funds are not so much an alternative to active management as an addition. Intelligently implemented, the two styles complement each other.
How to invest
Financial subjects can be complex in nature. Our ’How to Invest’ series aims at explaining them - one step at a time.