Why active investing still has an edge
January this year brought the sad news that Jack Bogle had died. Mr Bogle, the founder of the Vanguard Group, was the great pioneer of passive investing. Since he began to promote index-tracking funds in the 1970s, there’s been a huge increase in their use. This increase accelerated with the arrival of exchange-traded funds in the 1990s and then in the aftermath of the financial crisis, which led to a five-fold surge in assets in passive strategies. That growth has come at the expense of active managers – and the trend looks set to continue.
On the face of it, this makes sense. Fees for passive strategies are low, and investors are guaranteed the same return as the index they track. You won’t outperform the index, but you won’t underperform it either – and you’re not paying extra for the chance of either outcome.
It’s especially easy to feel comfortable with passive after a decade-long bull market. Since the end of the global financial crisis, most major equity indices have performed resoundingly well. And that, of course, means that passive strategies have performed well too.
In recent months, however, we’ve seen signs that the long bull market may be coming to an end. Volatility has risen, and there are signs of a slowdown in the global economy. Investors are having to consider the possibility of a prolonged downturn in markets.
That should prompt questions about the efficacy of a passive approach. Passive investors cannot escape the full impact of a market downturn. On top of that, passive investment has an inherent weakness. By replicating index weightings – buying stocks that have done well and selling those that have fallen – a passive strategy ‘buys high and sells low’. That’s precisely the opposite of conventional investment wisdom.
In this way, passive strategies create a more momentum-driven market. When they rebalance each month or quarter, they buy more of the assets that have risen most – driving their prices up still further in the process. That increases the risks of asset-price bubbles.
It also means that passive strategies tend to back long-established companies that may already have peaked. An active manager could have gone overweight in Amazon, for instance, when it first joined the S&P 500 in 2005; far better to do it then than when it temporarily achieved a market capitalisation of over $1 trillion last September. But passive investors could never take such opportunities.
“…active managers are free to seek out stocks that have low market capitalisation but enormous potential for growth…”
In contrast, active managers are free to seek out stocks that have low market capitalisation but enormous potential for growth – or stocks that are trading well below their true value because the market’s attention has been drawn elsewhere. And active investors can also seek shelter from the storm of a market downturn – by switching swiftly into defensive sectors and stocks.
Also, passive investing assumes that markets are efficient – that they react appropriately to information as soon it becomes available. But this isn’t always true. In particular, emerging and frontier markets are often under-researched and poorly understood. Some are driven by excitable private investors prone to backing fads rather than fundamentals. And developed markets also frequently succumb to behavioural biases. Passive allocations merely replicate those flaws.
Then there’s the question of investor goals. If the aim is to replicate index returns, then passive investment is the perfect tool. But often, investors seek markedly different outcomes. These can include capital preservation, steady income or socially responsible investing. In each case, active management offers significant, or even overwhelming, advantages over passive.
Stewardship is important here. Ordinary investors are increasingly concerned about where their money is going. A growing emphasis on environmental, social and governance (ESG) concerns means that there are obvious problems with the automated assignment of capital according to market capitalisation. Assessing a company’s ESG qualities takes time, commitment and engagement. Promoting positive corporate change is a slow, painstaking process – and one that requires active human involvement.
None of this is to belittle Jack Bogle’s revolution. Low-cost access to markets is a good thing. One lesson from the rise of passive is that there’s no place for managers who aren’t genuinely active. ‘Closet trackers’ – supposedly active managers who cling close to their benchmarks – are being weeded out. This improves the financial ecosystem.
But genuinely active management will always have a place in a well-balanced portfolio. That’s true even if that portfolio consists entirely of passive strategies – because deciding how much to allocate to each asset class or market is itself an example of active management. Passive exchange-traded funds are often the blocks used to build an active multi-asset strategy.
Ultimately, active and passive exist in symbiosis. Passive strategies cannot exist without active allocations to replicate. At the same time, passive strategies benefit active managers and their clients by forcing them to offer something genuinely distinctive. That symbiosis is something that all investors should appreciate – especially at a time when the perils of a purely passive approach are becoming apparent.
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