Passive v Active: A Chief Investment Officers view: Part 1

There are many articles debating the qualities and virtues of passive investing, while at the same time eschewing the benefits of active investing.  Equally, there are a similar number of commentaries voicing the values of using an active approach, while focusing on the detriments of passive investing.

Within our own investment process we look at whether we want to have an active or passive position for a particular asset class.  For active management we are looking for the ability to generate alpha (over a given investment term) where we have our highest conviction.  For passive management the main consideration is will the investment replicate the discrete exposure that we need?

All of these questions have an underlying foundation of having a long term investment horizon as that is where we consider we have a clearer view of where we want to be invested and as such, can have a greater degree of conviction in our investment decisions.

Long term investors are well placed to exploit factors that crystallise slowly, such as demographic trends, emerging market and emerging wealth dynamics and resource degradation.  Over the long term, the return on an asset class is driven by fundamental factors.  Over the shorter term, the return on an asset class is subject to the forces of supply and demand (liquidity, momentum and speculation).  Hence, the shorter term returns from beta are typically volatile.

Rather than a paper debating the merits and demerits of passive and active investing, it seems to me that the underlying foundation is short over long term investing.  Active management lends itself to longer term investing, which as a holistic approach to investing, is what we strive for; strong, longer term investing, withstanding the deflections of short term distractions.

Passive management particularly lends itself to short term investing, as the style is linked to momentum investing, as the bias is towards investing in those stocks that are rising in value, giving passive investing a more growth or momentum tilt.  Many investors use Exchanged Traded Funds (ETFs) to gain short term exposure to Beta in a liquid investment.  When we have short term measurement against market benchmarks, this can end up being counter-productive, as frequent monitoring can contribute to short term investing.  In my view the statistics used to support passive management are a distraction from what is really important: good fund selection based on qualitative, and not just quantitative, judgement.

Within our own PRETTI process we look at returns, but more importantly we look at Team, Talent and Ideology as the bedrock for a fund.  Ideology is about understanding why a fund manager is able to beat the market and much of that answer will come down to process (the ‘P’ in PRETTI), as it is important to understand whether or not the manager consistently maximises market inefficiencies with good processes, avoiding luck and maximising skill.

The most important element is people, as this industry is all about Talent and the Teams in which they work.  If you have the right people with a clear philosophy and a good process, it is likely that performance will come independently of any ‘star’ ratings.

Identification and selection of skilful investment managers is difficult but should be successful over time if based on future return expectations, which, in turn, are based on rigorous application of research into qualitative and quantitative factors.

One interesting outcome of the passive versus active debate, is the symbiotic need for each other; the active manager’s arbitrage role is important in ensuring that stock prices and estimated value are not so far away, and security prices reflect all available information.  In a world without active management, passive investments could increase the boom and bust cycles in stocks through their momentum style.

I take a look at both UK and US markets from an active v passive perspective, in parts 2 and 3 of this series, and then end with my conclusion and summary on this debate. I hope part 1 has proven to be a good “scene setter”

*Equip is the name given to our risk based investment process