New Twists to the Active vs. Passive Debate
The growing popularity of passive equity investing seems to be an unstoppable feature of the evolving investment industry. According to the 2014 Investment Company Fact Book, the passive index equity share of US mutual fund assets has risen from 11.4% to 18.4% in the past decade. More recent analysis by Morningstar, aggregating data on mutual funds and exchange-traded funds (ETFs), suggests passive investing is now the default choice for American investors, attracting an astonishing 68% of the past 12 months of investor inflows. With many difficult and potentially confusing theoretical investment issues still unresolved, I revisit some aspects of the active versus passive debate.
It’s worth starting with the confusion caused when some participants in the debate use the term “active investment” to indicate something like Warren Buffett’s investing style at Berkshire Hathaway Inc. (BRK.A and BRK.B). In fact, the distinct financial success of Berkshire often becomes an argument used to belittle many of the complexities and subtleties involved in active management. This is an unfortunate error. A recent op-ed in the Economist reviewed Buffett’s superlative record of growing Berkshire into America’s fifth largest company and lamented what could happen when he is gone. According to another study, several underlying features of Buffett’s portfolio can be identified and potentially replicated: All investments are in high-quality stocks that are stable, profitable, and growing, with high payout ratios and low price-to-book ratios.
In general, though, Buffett’s approach is probably too unique for any regular active mutual fund to replicate. Over an unusual historical time period, he has exploited low-cost leverage, something mutual funds can’t usually deploy, to seek out an abundance of low-volatility earnings streams, favoring investments with both a strong ethical culture and quality management. So, unfortunately, the circumstances of Buffett’s story seem unlikely to exactly reoccur.
A more helpful discussion of active investment is suggested by Jacques Lussier, CFA, in a new book, Successful Investing Is a Process: Structuring Efficient Portfolios for Outperformance. Active managers cannot all be better than each other. Looking down at the whole industry from a figurative mountain top, conducting active management against a benchmark often means wealth is unproductively shuffled between investors at rival firms. Active managers most often pull returns down to (or below) the benchmark, a concept itself often distorted by survivorship, size effects, wrong choice of yardstick, and the fact that management styles move through long cycles. True investment success comes from a careful review of research evidence coupled with simple, real-life investment analysis. The solution is a focus on process and protocols with attention to solid evidence and ease of implementation.
Somewhere between active and passive management is the increasingly popular factor approach, which offers investors the chance to isolate various return drivers, or “factors,” to achieve more transparent and better returns at lower costs. This is an approach that has been already embraced by the fund indexing and ETF industry, where several factor-based products are available. The factors researched traditionally include size, value, and market risk factors, and these have now been joined by three new factors: profitability, liquidity, and carry. One recent study by researchers at the University of Hong Kong and University of Wisconsin looks to identify the impact of commodity prices on investment returns. Forecasted commodity prices are undoubtedly important to the success of many investment strategies. The authors evaluate the extent to which a simple static factor model captures co-movements in commodity prices.
Looking to the isolation of other influences, a trio of researchers from the asset management group AQR explores whether investors would benefit from the evaluation of their portfolio exposure to different macro factor risks. Superior portfolios can be constructed if investors know an investment’s sensitivity to a variety of macroeconomic environments.
Meanwhile, research efforts continue to find stock market anomalies and seeming inconsistencies with the efficient market hypothesis. A research paper by Pavel Savor at Temple University and Mungo Wilson at Oxford University finds that a strong direct relationship exists between stock market beta and average asset returns on announcement days (a-days) of important macroeconomic news. In fact, a stable and robust market risk–return trade-off is noted to be confined exclusively to a-days, which seems just as noteworthy as other calendar-related market anomalies, such as the January, “turn-of-the-month,” and Monday effects.
When passive investing first appeared, some commentators deduced that belief in market efficiency could be taken to the ultimate degree — the creation of a few giant, low-cost global passive funds, each owning 20% of world equity markets, robotically replicating changes in market cap indices. Under this scenario, active investors would be squeezed out and gradually eliminated. It never happened, but growth of both passive and active investment has led to the creation of some sizable asset managers. In “Are Asset Managers a Source of Systemic Risk?,” the impact of large asset management firms compared with other financial institutions is reviewed. The author concludes on a cheerful note that largely unlevered asset management firms, unlike banks, provide stability and excellent liquidity during a severe financial crisis.
Recent CFA Digest summaries and related resources of interest to readers are summarized below:
- Successful Investing Is a Process: Structuring Efficient Portfolios for Outperformance: Using 50 years of theory and empirical evidence, the author presents processes, or protocols, for investment success. He focuses on using effective tools for managing more efficient portfolios without relying on forecasting skill. The book develops protocols that appreciably improve portfolio efficiency.
- Exploring Macroeconomic Sensitivities: How Investments Respond to Different Economic Environments: Investors would benefit from the evaluation of their portfolio exposure to different macro risks in addition to simply assessing their asset class risk exposure. More robust portfolios can be constructed if investors are aware of an investment’s sensitivity to certain macroeconomic environments. Data support diversification within asset classes and styles and suggest the inclusion of alternative long–short styles for institutional portfolios seeking risk diversification.
- Asset Pricing: A Tale of Two Days: A strong direct relationship exists between stock market beta and average returns, which the authors find when they examine market pricing of various assets on announcement days (a-days) of important macroeconomic news. The finding confirms beta’s importance as a systematic risk measure. A stable and robust market risk–return trade-off is noted to be confined exclusively to a-days.
- Factor-Based Approach Gains Momentum: Academic research has led to the expansion of the current factor model — which has traditionally included size, value, and market risk factors — to also incorporate profitability, liquidity, and carry as factors of investment return. Often included in alpha, these factor exposures are better thought of as market betas. Increased transparency into return drivers can help investors achieve better returns at lower costs.
- A Factor Model for Co-Movements of Commodity Prices: Forecasted commodity prices are important to the success of many investment strategies. The authors aim to evaluate the extent to which a simple static factor model captures co-movements in commodity prices. They find that commodity prices display a tendency to revert toward two factors, with one factor being very dominant.
- Are Asset Managers a Source of Systemic Risk? Asset management firms can have an impact on global financial stability because of the potential incidence of significant financial losses or failure. The author discusses the impact of asset management firms and how it compares with the impact of other financial institutions.
- Berkshire Hathaway: Playing Out the Last Hand: Warren Buffett has overcome numerous challenges to grow Berkshire Hathaway into America’s fifth most valuable public company. One of the biggest challenges his company will face over the coming years is the transition to new management.
- Buffett’s Alpha: Warren Buffett is a seminal figure in investing: $1 invested in Berkshire Hathaway, his investment firm, in 1976 would have been worth more than $1,500 in 2011, an astonishing record. The authors examine how Buffett generated sizable alpha over many years to determine what factors might explain his performance success and whether creating a portfolio with similar characteristics and outsized returns is possible.
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