Why the active/passive debate is flawed
No debate in the industry has been more misrepresented than the active/passive one.
With the exception of the FSA, nothing seems to devour more column inches in the investment press than the battle between actively and passively managed investments. In spite of the war of words, however, no debate in the industry has been more misrepresented.
So rather than summarise the arguments made so far – if we did so, this column would cover not just inches but pages – let us briefly review the issue from first principles.
Even if an investor allocates passively to an index of assets or an investment fund that claims to target certain risks and returns, the choice to allocate is active
The point of investing is to pick a diverse range of investments which will meet the investor’s goals over time – without, as the cliché goes, putting all their eggs into a dangerously low number of baskets. Investors will pick a number of different buckets of asset – so equities, bonds and so forth – that match their appetite for risk and the returns they are seeking to achieve. They will then fill these buckets with individual financial instruments or baskets and indices thereof, which in themselves will offer varying risks and returns.
Picking these asset buckets is an active, individual choice. No appetite for risk or need for returns is identical. Even if they are similar, there is no one theory about which combination of assets will meet them. Even if an investor allocates passively to an index of assets or an investment fund that claims to target certain risks and returns, the choice to allocate to it is active.
The second half of the debate – populating asset allocation buckets with individual instruments or baskets of them – is currently more closely contested. Retail fund managers who track the performance of an index cheaply by investing passively in its constituents rightly argue that their peers on average underperform them if they try to take more active bets on the same instruments. Even if a fund looks above-average in past market conditions, that is no guarantee it will be above-average in future.
However, this exclusive obsession with returns relative to an index is concerning. You can invest in UK equities because you think the index will make you enough money in return for a tolerable level of risk – in which case, passive investment is a better way to go.
But you can also invest in the UK stockmarket because you believe it features a diverse spread of individual stocks – rather than an index as a whole – that will enable you to fulfil these same goals.
All you need, in most cases, is an active manager to pick appropriate stocks for you and ensure those goals are met – irrespective of the behaviour of the index. In the latter case, whether an active manager outperforms or underperforms is a secondary consideration.