If nearly all investors engage in active management through the development or selection of a portfolio’s asset allocation, then what is the active versus passive management debate all about?
The debate is whether individual asset classes should be accessed via active managers or via passive strategies. Thus, the debate over active versus passive management is at the asset class level, rather than portfolio level (because all investors are active at the portfolio level!).
Below is a brief summary of active and passive management:
The traditional form of investing, where an investor picks individual securities that he or she expects will result in the best risk or return metrics.
At some point (I think in the 1950s) investors began to both deduce and notice that active managers (in the aggregate) could not outperform the average returns in various markets. If managers could not beat the averages, then investors would be better off accepting average returns and minimizing costs. Average returns could be nearly achieved by simply buying the entire market or a representative sampling of them.
Below is an example of where an investor must decide whether to utilize an active or passive strategy:
A hypothetical investor decides to allocate 10% of her portfolio to emerging markets bonds. The investor can do one of two things with the 10%:
- Purchase individual emerging markets bonds (or hire a manger that selects the “best” bonds, based on research, analysis, etc).
- Invest in a passive strategy that attempts to mirror the risk and return characteristics of the broad emerging market bond market.
If the investor is comfortable with the risk and returns of the broad emerging market bond market, she should consider a passive strategy. If not or she thinks that she can beat this market, active management may be a better choice.
It should be clear that neither active management nor passive management is inherently better. The decision to use one over the other should depend on both investor objectives, as well as the asset classes’ characteristics and market structure. Yet, the debate does carry on, which I believe is driven both by bias from investing product sponsors and by dogma from under-informed investors.
Looking ahead, we will examine various asset classes and how active and passive strategies fare in each.