| 01 June
Active vs. Passive Revisited: Six Observations
Posted In: Drivers
of Value, Economics, Equity
Measurement & Evaluation, Philosophy, Portfolio
Two institutional managers I know — one at a Fortune 500 defined
benefit pension fund and another at a municipal pension fund and later
an endowment — believe in going all-in on active management. To them,
a 100% active allocation is not only okay but desirable. Of course,
anyone with any knowledge about the statistical odds of selecting
outperforming active managers knows how unbelievable and wrongheaded
this approach is.
Which is why I ask active management’s true believers to share their
academic and professional insights on why active is the better path.
I’ve found it startling that so many in our industry, when they offer
any opinion on it all, provide so little in the way of strong and
substantiated sources to back up their perspective.
For my part, I have six observations, detailed below, that help guide
my approach to the active vs. passive question. Of course, they are
far from exhaustive.
After all, manager selection is hardly a simple process. At bottom, it
begins with the assumption that active managers can outperform and
that those managers can be identified ahead of time. To be sure, the
manager selection literature has a vocabulary and a reasonable
framework to think about the challenges, but the holy grail of the
dilemma — knowing when to go active and when to go passive — remains
Indeed, active analysis hinges on reasonable forecasts of ex-ante
alpha and active risk both in terms
of optimizing alpha and strategic asset allocation.
To serve our clients well, we have to keep our eyes wide open on these
issues. Active management’s record is dismal. The
SPIVA research paints a pretty troubling picture.
So does Winning
the Loser’s Game by Charles Ellis, CFA, and “The
Active Management Delusion: Respect the Wisdom of the Crowd”
by Mark J. Higgins, CFA, CFP. Just last month, Charlie Munger
described most money managers — that’s us — as “fortune
tellers or astrologers who are dragging money out of their clients’
While Munger is always great for one-liners, the criticism stings and
maybe hits a little too close to home for many of us.
Yet, I have not forsaken all active for passive. But I am taking a
hard look, along with others in my firm and in the industry, at how to
work through these challenges. Make no mistake, our industry will
continue to bend toward passive. But there are possibilities for
active. When it comes to manager selection and the active vs. passive
debate more generally, I recommend keeping the following in mind:
1. There Are No Bad Backtests or Bad Narratives.
This is especially true coming from sales or business development
personnel. But while it is easy to sound good and construct a
compelling story, it is much harder to present a quantitative approach
that dissects attribution ex-post and understands ex-ante how that
process can materialize into alpha. It is a tall order and no pitch
that I have heard has ever done it well.
Investors should not have to figure it out on their own. It is
reasonable for them to expect active managers to define and measure
their ex-ante alpha, especially if they are simply extrapolating it
from the past. But investors have to evaluate that ex-ante expectation
or have a well-developed forward view of where that alpha will come
2. Non-Market-Cap Indexing May Help Identify Market Inefficiencies.
This extends active management into index selection and management.
Even small disparities can make a big difference when it comes to how
a sub-asset class performs in an index. For example, while
market-weighted and designed to reflect the small-cap universe, the
S&P 600 and Russell 2000 have very different inclusion and exclusion
criteria that can lead to material differences. Moreover, index
variations may seek to capture the well-known factors documented in
academic and practitioner research — the so-called “factor zoo” — that
too many have summarily dismissed.
3. Are Our Biases Our Friends?
If we truly question the efficiency of a market, we may have a basis
to prejudge a particular corner of the investment universe and invest
accordingly. But such beliefs must go beyond the general and the
obvious: We need something more concrete and specific than “the
markets cannot be efficient because people aren’t rational.”
4. When in Doubt, Go Passive.
We are all imperfect, but the strength of our convictions matter. If
on an ascending 1 to 10 confidence scale, we are only at 7 or even an
8, we should go passive. Given the odds, “warm” is not enough of an
inclination to go active.
and Manager Ownership Can Make for Good Screens
Does an active manager charge exorbitant fees? What does the fund’s
ownership structure look like? If the answers do not reflect well on
the manager or fund in question, it may be a good idea to avoid them.
6. Consider a Core-to-Satellite Approach
This gives us a mistake budget. We can, for example, limit our active
exposure to no more than 20% to 30% of our policy allocation. This way
our passive exposure will always give us reasonable expectations of
returns in the top-quartile over the long run. Top-quartile is
On a larger level, it may make sense to reframe the whole active vs.
passive debate. The question — active or passive? — may not be the
right one to ask. Am I getting exposure to the market that I cannot
get through a benchmark? Is there a real inefficiency in this market?
Perhaps these are the questions we should be asking ourselves.
All posts are the opinion of the author(s). As such, they should not
be construed as investment advice, nor do the opinions expressed
necessarily reflect the views of CFA Institute or the author’s
Image credit: ©Getty Images / Kkolosov
Professional Learning for CFA Institute Members
About the Author(s)
Benjamin Doty, CFA
Benjamin Doty, CFA, is managing director at Koss Olinger &
Company, based in Gainesville, Florida. Prior to Koss Olinger,
he worked at Galliard Capital. Doty began his investment
career as a credit analyst for a municipal bond fund. He
received a bachelor’s degree in economics and an MBA from the
University of Georgia.
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