As a member of the baby boomer generation, I grew up with a rotary dial phone in the house, I recall when we needed phones and computers and they had nothing to do with each other. Phones were just communication devices, while computers were gateways to limitless knowledge and entertainment. Nowadays, that distinction has dissolved. For many consumers, phones are their personal computers.
The world of investing too has evolved and diluted away from the distinction between active and passive investing. In the current landscape characteristics implied by such traditional, standardized labels may not be sufficient to describe many of today’s investment approaches.
Active investing, as its name implies, involved a hands-on approach to investing. The goal of active money management is to beat the stock market’s average returns and take full advantage of short-term price fluctuations using research and analysis to pinpoint when to pivot into or out of a particular stock, bond, or any asset. A portfolio manager usually oversees a team of analysts who look at qualitative and quantitative factors, then gaze into their crystal balls to try to determine where and when that price will change.
Active investing requires confidence that whoever is investing the portfolio will know exactly the right time to buy or sell. Successful active investment management requires being right more often than wrong. Over the years this has proved to be almost an impossible task.
Passive investors as opposed to active ones, limit the amount of buying and selling within their portfolios and buy the whole market in one go, making this a very cost-effective way to invest. The strategy requires a buy-and-hold mentality. That means resisting the temptation to react or anticipate the stock market’s every next move.
The prime example of a passive approach is to buy an index fund that follows one of the major indices like the S&P 500. Whenever these indices switch up their constituents, the index funds that follow them automatically switch up their holdings by selling the stock that’s leaving and buying the stock that’s becoming part of the index. This is why it’s such a big deal when a company becomes big enough to be included in one of the major indices: It guarantees that the stock will become a core holding in thousands of major funds.
Index investing emerged amid growing academic research that delivered evidence showing that traditional active methods of attempting to select stocks and time markets were ineffective. Studies documenting underperformance by active fund managers supported the sentiment that market prices were largely fair and any attempt to find under- or overpriced securities was akin to flipping a coin. So, the arrival of index funds represented a shift towards embracing market prices.
Because early indexing didn’t evolve from analysis or forecasting, it became known as passive investing.
However, a sailboat without an engine must still be actively manipulated to keep the wind in its sail. Indexes are not perpetual motion machines free of maintenance, but require active management through additions, deletions, and reweighting.
Also blurring the line between active and passive is the fact that some investors may use index funds to pursue an active investment approach. For example, the largest index the S&P 500 has the highest average daily trade volume of any US-listed securities in 2021, at $31 billion, according to Bloomberg. It is reasonable to assume a portion of that trading activity represented asset allocation changes motivated by market viewpoints, rather than buy-and-hold position accumulation.
Add to the equation the recent addition to the asset allocation “alternatives” that are capturing significant market share and attracted over 30 trillion USD in AUM.
There are Two Main Types of Alternative Investing
First are private assets such as private equity, private credit, infrastructure, and private real estate. They are more complex and less frequently traded than public stocks and bonds and give investors access to additional sources of return. Hedge funds, the second type, operate mainly in public markets but use less traditional tools such as short-selling and leverage.
While active and passive sound like opposite ends of a spectrum, they often have one trait in common: inflexibility. There is always the need to align yourself with market realities. Ironically, even index fund managers typically also trade urgently—only there generally is no discretion over what securities to buy and when to buy them, as the index dictates that decision, so the active management is not on the actual underlying equity but the asset class.
Alternative investments however typically don’t correlate to the stock market at all, which means they can be used to add diversification to a portfolio and help mitigate volatility. Some can also offer tax benefits not available in traditional investments.
Like any investment, the rate of return for alternatives is not guaranteed, but there is potential for it to be higher than that of traditional investments.
The Key is not in the Investment Strategy but in Understanding the Client’s Needs
Recent academic research from the world’s leading Universities (Oxford, Yale, Harvard & Cambridge) shows that proponents of alternatives in the portfolios of individual investors maintain they now have access to sophisticated investments and potentially higher returns that until relatively recently were only available to institutions, such as pension funds and foundations.
So, to answer the question of whether the Active or Passive Debate is over, it is my humble opinion that it is not as relevant as it was in the past. We now have a wide variety of tools to help clients achieve their life goals and after we understand what they want to achieve it is our calling to assemble these blocks in the most efficient way to live a life of dignity and security.
The key is not in the product or the investment strategy but in understanding the client’s needs.