The Debate Rages On: Active vs. Passive

By Palladiem

For over 30 years, the industry has debated the merits of active versus passive money management. From my standpoint, it’s all active management! The process of aligning assets with future liabilities is an active process.

The process of reviewing and executing on investment decisions with respect to costs and the effects of inflation is an active one. Even so-called passive index-based ETFs are not strictly passive; human judgment is used to determine methodologies and rebalancing rules.

The rapid rise of ETFs and the popularity of “smart beta” investment strategies have played into this debate and further confused the issue. However, actively managing systematic risk or beta, other than market beta, is clearly an active approach. Yet so many in the industry spend endless hours debating the merits active versus passive when it is merely semantics.

Regardless of the industry jargon, if pursuing a traditionally passive approach, investors should understand what buying the market really means. A market weighted index of securities is a reflection of all investors’ (both informed and uninformed) view of prices. Simply accepting this approach may be counterproductive for an investor striving to meet their own personal financial objective.

Whether implemented using purported passive ETFs or more overtly active ETFs, advisers and clients should embrace an active approach to portfolio management. In my view, such an approach removes the focus from beating the market and places it on something more meaningful – the investor’s long term financial objective. In addition, I believe it leads to better diversified portfolios, which is key during a market downturn.

Opponents of active management claim that the results do not outweigh the costs, and many traditional actively managed products may prove their point. However, the proliferation of ETF variants, which allow sector, region, or factor exposures, has created a low-cost, active management niche. Even key voices at Vanguard, one of passive management’s iconic institutions, believe there is a place for active management. Tom Rampulla, managing director of Vanguard’s Financial Advisor Services division, recently said there is a place for active management of portfolios, primarily in applying ‘tilts’ based on factors such as volatility and income in single factor and multifactor portfolios.1 Advisers seeking to adopt an active approach should consider whether their limited resources are best spent researching individual company investments, investments that focus on top down macro drivers of risk and return, or finding portfolio managers who are effective at either approach.

Ideally, an investor’s investable assets should be a mix of passive and actively managed vehicles. Whatever the implementation, I believe investors should place more emphasis on managing total portfolio risk and controllable factors, such as fees and trading costs. During the portfolio construction process, the focus should be on the key drivers of risk and return: whether that means market beta, smart beta, or specific security level risks. A forward-looking view and an understanding of the premia awarded for incurring these risks is crucial. Assessing and monitoring these risks effectively should not be a passive exercise, so investors need to be actively engaged or find a portfolio manager who is.

Palladiem is the advisor-centric investment firm; we provide targeted support and insight to advisors. We manage diversified, multi-asset class investment strategies designed to meet a wide range of investor risk/return objectives, supported by our proprietary investment process, forward looking views, capital markets analysis, and alternatives and investment manager research.

This article was contributed by Palladiem, a participant in the ETF Strategist Channel.

1 –ThinkAdvisor January 23, 2017. “Active Management Isn’t Dead, but It’s Evolving”