Finding the right balance between active and passive

For Australian investors, the above chart shows that during periods of market turmoil active management does appear to generate excess returns, with four out of the five most recent market corrections resulting in active management protecting capital better than a passive investment strategy.

This gives rise to the notion of sequencing risk—that is, the risk involved in the timing of investment returns. A portfolio suffering significant drawdowns in the 10 years prior to retirement—or the 10 years post retirement—may irreversibly damage future returns. Given that active managers deliver most of their excess returns during periods of high return dispersion (typically periods where the market draws down), a good active manager can help mitigate sequencing risk. This suggests the active versus passive decision should at least be informed by market cycle analysis.

Finding the right ‘active versus passive’ balance

Recent headlines that suggest ‘active management is dead’, are almost certainly premature. Still, active equity managers have increasingly struggled to outperform their benchmarks over the past couple of years. And there is little doubt, as we have discussed, that some of the key drivers for active outperformance remain under pressure—namely the lack of dispersion, the concentration of macro factors and the low volatility in overall market trends.

We believe, however, there will be sustained periods ahead where the current headwinds for active investing will fade, and potentially powerfully. With the macro and market cycle in its later stages, the likelihood of a significant risk drawdown inevitably increases, an environment where there must also be some uncertainty surrounding how the recent global increase in exposure to ETFs will impact relative passive investment performance and liquidity.

From a portfolio construction perspective, it is also important to remember that the recent sustained outperformance of passive strategies has its epicentre in large-cap developed equity markets. In contrast, active investing retains its place of prominence where idiosyncratic risk and the cost of information is high. This includes less developed equity markets (such as emerging equity markets), small to mid-cap equity investments, as well the broad gambit of alternative investments (private equity, hedge funds and real assets) where manager selection is of the highest importance. Moreover, as noted by Michael Buchanan, Deputy CIO of Western Asset Management, at the recent Crestone Investment Forum, a concerning global phenomenon is that investors in passive fixed income funds end up with the biggest exposures to the most indebted companies, and he takes the view that “active managers are uniquely positioned to outperform going forward”.

Finally, the drift away from pure active management in the equity space can take many forms, including more active (rather than purely passive) ETFs, as well as rules and factor-based investing (as noted by the Future Fund). These opportunities typically embody a fee structure that sits somewhere between purely passive and fully active mandates. Also, as the universe of passive and semi-passive investment opportunities grow, investors will increasingly need to consider which ones are appropriate for their portfolios.