Based on the information we’ve already reviewed about investment approaches, you can begin to see how it is difficult for “active management” to beat a “passive management” approach that relies primarily on buying and holding index funds. Let’s more fully define active versus passive management.
What is Active Management?
Active management* might best be described as an attempt to apply human intelligence to find “good deals” in the financial markets. Active management is the predominant model for investment strategy today.
Active managers try to pick attractive stocks, bonds, mutual funds, time when to move into or out of markets or market sectors, and place leveraged bets on the future direction of securities and markets with options, futures, and other derivatives.
Their objective is to make a profit, and, often without intention, to do better than they would have done if they simply accepted average market returns. In pursuing their objectives, active managers search out information they believe to be valuable, and often develop complex or proprietary selection and trading systems.
Active management encompasses hundreds of methods, and includes fundamental analysis, technical analysis, macroeconomic analysis, all having in common an attempt to determine profitable future investment trends.
What is Passive Management?
Passive investment management* makes no attempt to distinguish attractive from unattractive securities, or forecast securities prices, or time markets and market sectors. Passive managers invest in broad sectors of the market, called asset classes or indexes, and, like active investors, want to make a profit, but accept the average returns various asset classes produce.
Passive investors make little or no use of the information active investors seek out. Instead, they allocate assets based upon long-term historical data delineating probable asset class risks and returns, diversify widely within and across asset classes, and maintain allocations long-term through periodic rebalancing of asset classes.
*Source: Evanson Asset Management
What is Index Investing?
Index investing is a form of passive investing in which portfolios are based upon securities indexes that sample various market sectors. They are often called benchmarks. Best known of all indexes is the Dow Jones Industrial index, a basket of thirty large U.S. companies. Another common and more representative index is the S&P 500 Index, which tracks 500 large U.S. corporations. Indexes are available for domestic and international equities, fixed income, industry sectors, commodities and gold, and virtually all asset classes and sub-asset classes.
Asset Allocation vs. Security Selection
There is debate about what determines a portfolio return the most: the ability to select the best individual securities or the decision about what percentage of each asset class to hold.
In a landmark paper published in 1986, “Determinants of Portfolio Performance,” Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower concluded that asset allocation is the primary determinant of a portfolio’s return variability (not total return levels), with security selection and market-timing playing minor roles.
In the past decade, several authors revisited the Brinson study, updating or challenging it. Some research has confirmed the study’s conclusions. Others have criticized the study, or more accurately, its interpretation by the investment industry – and raised doubts about its applicability to general investors.
“The ultimate concern in the active/passive decision is whether active management can increase the returns and/or decrease the risks of a portfolio, not whether it decreases the portfolio’s R2.” R2 is a statistical measure that represents the percentage of a fund portfolio’s or security’s movements that can be explained by movements in a benchmark index. For fixed-income securities and their corresponding mutual funds, the benchmark is the US Treasury bill and, with equities and equity funds, the benchmark is the S&P 500 index.
“We find that, on average, active management has reduced a portfolio’s returns and increased its volatility compared with a static index implementation of the portfolio’s asset allocation policy. However, active management creates an opportunity for a portfolio to outperform appropriate market benchmarks.” Source: Vanguard paper
The most important contribution of Brinson and colleagues was the attribution of a portfolio’s total return to indexed static asset allocation policy, security selection and market-timing components.
They showed that, on average, pension funds have not been able to add value above their static indexed policy returns through market-timing or security selection. This result is consistent with the observation that indexing outperforms a significant portion of active portfolios in equity and bond markets.
1. “Due to the distinct return patterns of asset classes, the impact of one asset allocation choice versus another on returns is generally modest and relatively stable over time. The influence of security selection and market timing on returns can be more significant. However, active strategies tend to have a high skill hurdle, less stable and less predictable relative returns over time, and higher costs.”
2. “Unless there is a strong belief in the ability to select active managers who will deliver higher risk-adjusted net returns, investors’ focus should be on the asset allocation choice and its implementation using broadly diversified, low-cost portfolios with limited market-timing.”
Check out this article, “The Great Fund Debate About Indexing Isn’t Much of a Debate.”