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Blogs

The great investment strategy debate: active or passive management?

Sid Queler

August 27, 2021

Understanding the difference between active and passive strategies is important.

 

Active management

Passive management

Objective

Pursue a defined investment objective

Mirror a specific index

Technique

Actively select assets

Own what the index owns

Performance goal

Outperform the market

Track the index performance

Decision-maker

Asset manager supported by analysts

The index

 

There is often debate about whether active or passive investment strategies deliver better returns over time. Both sides have merit, and many investment portfolios include both passive and active strategies.

What is a passive management strategy?

Passive investment strategies attempt to replicate the performance of a specific index by holding the same assets the index holds. For example, there are 500 stocks in the Standard & Poor’s (“S&P”) 500 Index (“Index”), so a passive S&P 500 portfolio will hold those 500 stocks and weight them as the Index does. In general, this means investors know what to expect. Passive strategies will:

  • Invest in all securities held in a specific index
  • Participate 100% when markets move higher
  • Participate 100% when markets move lower

Sometimes, firms create their own indices for strategies to track, so it’s critical that investors understand what is in a specific index that a passive strategy is designed to track. In general, passively managed portfolios are an efficient way to gain exposure to a market, and they tend to be less expensive than active strategies because many have lower fees than actively managed strategies.

What is an active management strategy?

Active portfolio strategies give asset managers the discretion to select, and invest in, opportunities the managers think will outperform over time. The performance of an active strategy depends on its investment process, philosophy, managers and other qualitative factors. Truly active strategies will:

  • Hold carefully selected assets
  • Potentially outperform a given index
  • Potentially protect capital by reducing losses when the market moves lower

One advantage of active strategies is that they are selective, so they have the potential to capitalize on market anomalies. This can be advantageous in less efficient markets in which specialized knowledge and experience make a difference, such as small-cap stocks and emerging markets. Active management also may be a sound choice in less liquid markets, like the high-yield bond market, where replicating an index can be challenging. Active strategies tend to be more expensive than passive strategies because they often have higher fees than passively managed strategies.

Which is the better approach?

There has been a lot of research into passive and active management approaches. The findings often depend on the way the results are framed. For example, research that favors passive investing tends to compare all active strategies to all passive strategies. This approach often shows that, historically, a significant percentage of investments with active managers have underperformed their corresponding indices.

S&P Global, which manages indices, compared active strategies’ performance to indices around the world. In the United States, the percent of active large-cap asset managers—a relatively efficient marketplace—that underperformed the Standard & Poor’s 500 Index through December 31, 2020, was 75% over the five-year period, 70% over the three-year period, and 60% over the one-year period. [1]

Research that favors active investing defines “active” very carefully, because a significant percentage of “active” strategies are actually quite passive. These portfolios are known as closet index strategies. Managers of closet index strategies cling to an index, which means their portfolios are very similar to the indices they track. In the early 2000s, passive index strategies accounted for about 15% of mutual fund assets, while closet index strategies accounted for about 30% of assets.[2]

Active managers have distinct characteristics. Typically, they:

  • Hold assets that are not in the benchmark index
  • Do not hold all of the assets that are in the benchmark index
  • Hold assets that are in the benchmark index, but weight the holdings differently

Historically, highly active strategies have been shown to outperform benchmarks, especially when managers are “active stock pickers with long-term convictions.”[3]

The active management side of the debate also holds that passive strategies may expose investors to unanticipated risks, especially in asset classes like small-company stocks or high-yield bonds, where indices have higher-volatility, lower-quality, less liquid holdings.

Also, passive strategies tend to underperform the indices they track by the amount of the fee.

This may have little effect on broad asset classes where the fees tend to be very low, like large-cap stocks; however, adding the effect of the fee can have a significant impact on more esoteric strategies with fees that are similar to those of active strategies.

Will we see a passive-active rotation?

Since the 2008 financial crisis, there has been a significant increase in the popularity of passive management. These strategies have delivered attractive returns throughout the longest bull market in history, supported by accommodative monetary policy and low interest rates. However, when many people invest in the same way, prices may become skewed, creating market anomalies that active managers can potentially benefit from.[4]

While the debate about active and passive management is likely to continue well into the future, it’s not necessarily an either-or decision for investors. Many investors choose to include both types of strategies in their portfolios. If you would like to learn more about the role of these strategies in your portfolio, contact me at Sid.Queler@cibc.com or 617-531.6954.

 

Sidney F. Queler is the chief growth officer of CIBC Private Wealth, US. In this role, he leads the firm’s business development team, setting strategies and practices that broaden relationships with individuals, families, foundations and endowments. Sid also serves as a member of the CIBC Private Wealth US Operating Committee and as a member of the advisory team for the firm's Boston office. In addition to leading national business development, he remains actively involved with client relationships.