Active vs Passive, Still a Battle?

A battle has been raging on for the better part of 25 years within the financial community. This battle has come to be known as “Active vs Passive”. For first time readers who may be scratching their head, what exactly is Active and Passive? Let’s dive in deeper:

What is Active and Passive? Active Management, also referred to as ‘Active’, is the traditional sense of investing that has been around since the birth of Wall Street. Essentially this is the idea that a brilliant individual or team of MBAs and PhDs try to discover undervalued individual stocks and bonds. By knowing the value better than the perceived current price, this should lead them to great performance.

Passive Management, also referred to as ‘Passive’, has been around for much less time, culminating in the launch of the first index fund in 1975 by the late Jack Bogle, founder of The Vanguard Group. This is the idea that you are better off investing into an index, like the S&P 500, by being diversified and keeping costs low. Instead of betting on research to outperform, you bet on the fact that markets over time do well and no one person can consistently outsmart them. These philosophies are clearly at odds with each other, so what has been the recent trends?

What happened? As of December 31, 2018, passive strategies held $2.93 trillion in assets and active strategies held $2.84 trillion within the US Large-Cap space¹. We have seen this gap narrowing over the years, however this is most notable, as this is the first time ever passive has had more assets than active. It is important to note that Morningstar’s data defines passive based broadly on strategies within mutual funds, exchange traded funds, and smart beta or factor-based products. So passive is not purely indexing.

Why This Matters? There are a few reasons why this matters, two of which are intertwined – cost and performance. In general, passive strategies tend to have lower expenses than active strategies. As Morningstar has pointed out over the years, costs are a large determinant of a strategy’s relative performance.²

This is further echoed by an annual SPIVA (S&P Indexes Versus Active) study³, most recently as of October 2018. This shows the underperformance of funds within US Large-Caps measured against the S&P 500:

Although passive has been getting much attention (and fund flows), the debate continues to evolve and likely will never truly end. Why? Because there may be reasons for different strategies in different markets. We have seen the growth of smart beta and factor-based products, a tool BDF very much subscribes to. These strategies present a hybrid approach, offering lower costs along with the ability to outperform an index. Additionally, while the SPIVA data above is quite convincing, it is not as strong within other sub asset classes of the market, particularly fixed income.

With that being said, BDF’s Investment Committee needs to continue to look at all available options. While that has led to our strong tilt to passive, a world where still half the assets are invested actively warrants continued monitoring. This debate is not over, but one side is definitely picking up steam.

 

^{1 Passive Funds Overtake Stock-Pickers in the U.S. Large Cap Market – Bloomberg}

^{2 Fund Fees Predict Future Success or Failure – Morningstar}

^{3 SPIVA U.S. Mid-Year Scorecard 2018 – S&P Dow Jones Indices}