Trade-off against risk

The debate between passive and active investing has been raging for a long time, but the battle lines are often not accurately drawn.

We tend to define the difference between active and passive by whether we believe in stock selection ‘skill’ at the underlying single asset class level. If we do, we buy active managers, and if not we use ‘index’ strategies. But, as always, it is not that simple. Consider two issues with this split between ‘active’ and ‘passive’. First, should asset allocation between underlying asset classes also be passive? And second, even if you do not believe in stock selection ‘skill’, do you really just want to be invested in broad equity indices?

Even if underlying investments are ‘passive’ index replication rather than active, stock selection-based strategies, the decision of how much to allocate to various asset classes and sub-asset classes is unlikely to be a purely passive decision. An investor will take a view on a strategic asset allocation – that is the long-term split between asset classes that they want. Ultimately it is virtually impossible to be ‘passive’ in this allocation decision. For example, a ‘pure passive’ investor could simply weight all assets based on their total market capitalisation, but there still has to be a decision on which asset classes to include, and this approach would ignore both correlations and the investor’s risk profile. Anything else represents at least a one-off active investment decision. More than this, however, an investor is likely, once they have a strategic benchmark, to need to ‘rebalance’ their portfolio towards this benchmark on a periodic basis, or, of course, decide that their portfolio should ‘float’ forever. But any of these are, in their own way, an active decision.

Rebalancing does, though, have costs and a ‘quasi-passive’ approach may not actually be efficient in terms of minimising costs or risk. For example, what if it is clear that a market is in crisis? At what point do you want to be rebalance by increasing your exposure to Greek equities or debt? There might be a buying opportunity but a passive approach will only find it by luck, when judgement might be able to add substantial value.

Hence, tactical asset allocation can be a sensible approach, but this is in itself an ‘active’ investment strategy. In 2008 effective tactical asset allocation combined with underlying active investment managers who rotated, for example, to an underweight to financials, would have preserved substantially more capital than a passive investment strategy that could not react to the market environment. It is these times of extreme stress where pure passive investing can prove far more costly to an investor than its active counterpart.