The CFA Society of Washington, DC invited Lowell Pratt, CFA to participate on a panel debating the merits of active vs passive investing. The panel included Lowell as the proponent for active investing with another panelist defending passive and a third somewhere in the middle.
The conversation started simply by defining what it means to be a passive investor. Generally, passive investments are considered funds that hold every stock in a particular index, weighted by market cap. Popular indexes include the S&P 500 and Russell 2000, though there are plenty of other indexes with more broad exposure to stocks and other asset classes like bonds.
Passive investments aim to achieve a market beta of one by owning every investment option in a particular asset class. Passive investors focus on keeping costs low by choosing funds with lower expense ratios and periodically rebalancing to a predetermined mix of asset classes. The idea is to control what you can control – asset allocation, costs and taxes – and accept whatever returns the market offers.
Active investors believe it is possible to gain broad exposure to various asset classes while also tilting towards factors associated with excess long-term returns to generate alpha on top of the broad exposure to an asset class. It is still important in an active strategy to set an appropriate asset allocation and control costs and taxes but the idea of active management is that there are opportunities presented by the market to overweight certain investments and underweight others to achieve better returns than the market.
Proponents of passive investing point out that many active funds, at least recently, underperformed major index funds after taking into account fees. Certainly, funds with higher fees have a tougher time in this type of comparison as their fees act as a hurdle that needs to be cleared to justify their existence. But this point ignores that there are some active managers that have shown a consistent ability to outperform their benchmarks.
Even these top managers will underperform – the average top fund underperformed for a three year period, often substantially. This is an area where the panelists were able to find common ground. They all agreed the best investment strategy is the one a client can stick with. Clients who invest in active strategies need to be patient and tolerant of periodic times of underperformance. Often, the worst time to move on from a strategy is when the strategy is underperforming.
The night ended with an interesting question: How can you marry Active and Passive?
Lowell pointed out it is necessary to know where you have a comparative edge and where you don’t to choose whether to invest actively or passively. It is best to take a quantitative approach with a long-term focus and challenge convention. For instance, assuming past 30-year returns are a good proxy for next 30-year returns is problematic with direct implications for the success of many of today’s financial plans.
How do you marry Active and Passive?
– Quant approach
– Challenge convention
– Asset allocation includes alts for diversification
– Seek active opportunity where we can find it, index elsewhere
– Market style cycling
– Stock picking overlay, factor based— Burney Company (@BurneyCompany) September 6, 2018
He pointed out it is important to be fearless of failure and to continue to test ideas once implemented. Many of our ideas through the years have proven unsuccessful – such as attempting to incorporate AI into our process 20 years ago – but experimentation and conviction are essential for long-term success.