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In depth: along the active - passive continuum

There has been a great deal of debate recently about whether active or passive management is the right choice for investors. We believe this is the wrong question to be asking. Investors have a range of choices along a continuum stretching from pure passive on one side to fully active on the other and a better question to ask is how investors can use all the different options along this continuum to achieve their goals.

by James Bateman, Sonja Laud Head of Equities, Nick King Head of ETFs, Lucette Yvernault Portfolio Engineer, Fixed Income, Dorcas Phillips Director, ETFs, Barney Rowe and George Watson Investment Writer

04 June 2018, 15:55 GMT

To beta or not to beta?

Active or passive? Ever since passive investing entered the mainstream, investors have been asking themselves and their money managers this question. What used to be an active-only world morphed into an active-and-passive world or, more often, an active-versus-passive world, with investors encouraged to view the two styles of investing as mutually exclusive or somehow pitched against each other in battle.

Diagram 1: The active-passive continuumSource: Fidelity International, May 2018.

Framing the debate as active versus passive may have been excellent for headline writers but not so useful for investors. After all, investing is a means to an end. What we really want as investors is for the eventual outcomes to reflect our needs. Getting to that endpoint is a complicated business and to reduce investing to a choice of one out of two is both reductive and unnecessarily limiting. In fact, the space between passive and active is not empty but a continuum stretching from market capitalisation weighted exposure on one side to unconstrained investing on the other, with an increasing number of options in between.

  • Watch Multi Asset CIO James Bateman introduce the key phases of the active - passive continuum:

What’s in a name?

To complicate matters further, the terminology around active and passive has become stretched. What was adequate when there were only two options is no longer fit for purpose. Some people understand passive investing as pure beta exposure through a market value weighted index, while others consider passive investing to be any portfolio that is passively managed including systematic strategies that attempt to harvest alpha and may deviate significantly from the market.Add to this the reality that no investment is truly passive. The active-or-passive decision is just one active decision in a sequence of active decisions – first you must choose your asset allocation, then whether you will tactically over or underweight that allocation depending on your current market views and finally your allocation within asset classes. And after all that, if you decide that a market weighted exposure to US equities best meets your needs, you then have to decide if the S&P 500, the MSCI USA, the Russell 1000 or some other market index is the right exposure for you.It is not the end product that really determines how active or passive you are. An investor who buys and holds the S&P 500 index over the long term can probably safely consider themselves a passive investor. However, more granular passive products can be very useful to get exposure to a specific theme or segment when implementing active views. Accordingly, most would consider using the S&P 500 Financials index to make a tactical bet on the prospects of further US rate hikes the behaviour of a relatively active investor. The terms active and passive can be misleading.

Assets of Equity ETFs as of April 2018. Source: Nasdaq, Fidelity International, May 2018.
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Source: Thomson Reuters, Fidelity International, May 2018.

Focus on solutions

Technology, changing regulations and lower returns since the global financial crisis have all played their part in spurring on a focus on solutions rather than just products, as the difference between active, passive, and everything in between has become less distinct and less important than meeting investors’ desired outcomes.Investors have to balance the three competing forces of risk, return, and cost. Each approach on the active-passive continuum has benefits and drawbacks, times it will do well and times it will do poorly, times it will be suitable and times it will not. No one position is inherently or consistently superior; the relative benefits can only be judged by the investor’s individual requirements.

Pure beta

At the very far end of the continuum is pure beta exposure through market value-weighted indices. The benefit of this type of investment is broad, diversified exposure at a low cost. Passive index trackers might be appropriate for investors who are particularly sensitive to costs, who think alpha is hard to come by in a particular region or asset class (US large cap equities are a good example), or who find it difficult or expensive to identify good managers.

As of December 2017. Source: Morningstar, Fidelity International, May 2018.

The downside of market value weighting

The drawback of pure beta investing is obviously settling for a market average rate of return – minus fees. Market value weighted indices also have an inherent design flaw – they determine intrinsic worth from market value, which is not always a rational judge, driven sometimes by emotion, momentum or factors entirely unrelated to the asset itself. While the simplicity keeps turnover low and means the index is liquid, the more highly valued a stock becomes or the more indebted a bond issuer becomes, the more of that security you must purchase, exposing the investor to risk while ‘buying high’ and ‘selling low’.Also, many assets do not lend themselves to passive investing. Fixed income indices are difficult to replicate since an index typically contains thousands of securities, many of which are not liquid. Other illiquid asset classes such as real estate, private equity and infrastructure are not well served by market weighted indices.

Above and beyond pure beta

The next area on the continuum is smart beta. Products in this area aim to improve on the risk or return characteristics of pure beta exposure or provide access to specific investment styles and themes but in a systematic way. The rules may be slightly more complicated but they are still transparent and consistent, and smart beta strategies still primarily invest in underlying securities rather than derivatives. Investors are able access some of the intellectual property of the index designer at a lower cost than discretionary management.Smart beta is used in a number of ways. It can give a greater degree of flexibility to a portfolio as investors are better able to target the risk factors that meet their individual goals without straying too far from the passive end of the continuum. It can also be used for complementary factor diversification from a risk budget point of view – if you favour an active manager who focuses on small cap value stocks, you can diversify your exposure by allocating elsewhere to low volatility or quality smart beta indices much more effectively than using market weighted indices. What was introduced as a satellite exposure is now also used as a core building block, replacing or supplementing both existing passive and active exposures.

Performance of MSCI factor indices 09/01/2002 - 09/05/2018. Indices shown are MSCI Word Enhanced Value, MSCI World Minimum Volatility, MSCI World Momentum, MSCI World Small Cap, MSCI World High Dividend Yield, MSCI World Quality, MSCI World Diversified Multi-Factor and MSCI World. Source: Thomson Reuters, Fidelity International, May 2018.
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Source: Thomson Reuters, Fidelity International, May 2018.

Smart beta’s limitations

While smart beta products aim to provide smarter exposure to beta, they still come with a hefty dose of beta exposure, meaning most of the absolute performance will be determined by broad market movements. Another consideration is that factor performance in equities is well known to be cyclical – momentum tends to perform well when the market is trending but often struggles when the market cycle turns, for example. Investors can always chop and change between strategies but whether it’s possible to effectively time smart beta strategies is the subject of much debate in the industry and your view on this often depends on your view of whether it is possible to time financial markets in general.Turnover in smart beta strategies is likely to be higher than capitalisation-weighted indices, meaning cost-conscious investors should look beyond a simple expense ratio. Finally, as smart beta strategies have attracted assets, so they have garnered greater scrutiny – many believe that since the rules of smart beta indices are publicly available, the strategies will become crowded and the risk or return benefits they attempt to capture could be eroded in time.

Chart shows year-on-year total return of MSCI World factor indices minus the year-on-year total return of the MSCI World index. Indices used are MSCI Word Enhanced Value, MSCI World Minimum Volatility, MSCI World Momentum, MSCI World Small Cap, MSCI World High Dividend Yield, MSCI World Quality and MSCI World Diversified Multi-Factor. Source: Thomson Reuters, Fidelity international, May 2018.

Combining active and passive through quant investing

Further still down the continuum, we move into the area of quantitative investing, which attempts to combine active research and systematic market signals to capture alpha in a systematic way. Broadly speaking, this area of the continuum seeks to provide some alpha at a lower cost compared with active management. Quantitative portfolio construction can be used to achieve highly customised and efficient portfolios even in a tightly regulated environment. Alpha can be broken down into asset allocation and security selection, with a quantitative investment process then used to help position the portfolio on an investor’s personal efficient frontier. Investors can decide which risk factors they would like active exposure to and which they would like pure beta exposure to. In this way, two key component parts of active management, security selection and portfolio construction, are being unbundled so that investors can take advantage of active research to select the securities in a portfolio that is managed in a systematic way.For example, a fixed income investor with a high conviction view about active duration management might allocate the majority of their risk budget to active exposure to that factor, while opting for broad market exposure to credit risk and neutralising currency risk altogether via hedging. Likewise, an equity investor who feels there is an opportunity to add value through active research in small caps can choose to have high active exposure to in this area and pure beta exposure to other factors. These elements can then be used to construct a portfolio that is managed in a systematic way, with the ability to customise the rules by excluding certain securities or sectors in addition to meeting individual constraints over costs, desired return, diversification and so on.

Diagram 2: Quantitative fixed income portfolio construction using active researchSource: Fidelity international, May 2018.

Enhancing active research in equities

Quant strategies are also used in equities to combine active research and intellectual property in a systematically constructed portfolio. Early iterations used large sets of structured data to guide security selection or optimise portfolio weights. While this approach is still popular, recently the trend has been to incorporate psychology to take account of – and hopefully improve – the imperfect way humans make decisions.An example of this is trying to reduce the effects of loss aversion. Active research can be used to select securities for a portfolio which can then be managed according to a set of rules designed to help combat the urge to hold losers for too long when prices head south. The result is an equity-like return profile but with improved downside protection. Another example of using algorithms to improve human decision making is in the analysis of company accounts. Trawling through company filings to look for that nugget of value can be time consuming and, frankly, boring. Humans have limited tolerance for tedium and regulatory filings are sometimes designed to bury important (especially negative) information to make it hard for even the most diligent analyst to dig out. Which is why nudging them towards pertinent information and presenting it in a format likely to be digested more easily is another way that active investing is being enhanced by advanced computing. A computer can find and highlight relevant information more easily, but a human can better judge its importance in context.

Enhanced fixed income indices

A similar melding of active and systematic investing can be used to enhance fixed income indices. The nature of bond indices means they are very difficult to replicate exactly as they often contain thousands of individual securities. This means that index tracking portfolios are usually constructed with a stratification investment process – holding a representative basket of liquid bonds and derivatives to provide performance as close to the index as possible.

Number of securities in portfolio. Source: SSGA, Blackrock, Charles Schwab, Bloomberg, Fidelity International, May 2018.
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Source: Thomson Reuters, Fidelity International, May 2018.

The act of selecting which bonds should be in the sample is already a discretionary decision, and choosing them solely based on liquidity can be sub-optimal. Investors can instead choose how an index sample is picked, for example by using active research to select bonds with a lower default risk or exclude issuers with lower ESG scores. This suits those looking for market-like returns but willing to leverage active research to tweak a portfolio to suit their investment goals where possible.

Active management

The last area on the continuum is active management. Alpha is the name of the game here, as skilled market participants attempt to add value to investments over and above the market. At the very end of the continuum are long-short strategies that remove all market exposure, leaving only alpha.Almost as important as the active management itself is the process of manager selection. Whether active management is a zero-sum game is the source of some debate (and we don’t agree with the debate being framed like that) but what is clear is that there is a gulf between the best and worst performing managers which must be factored in to any discussion about active management.

Pros and cons of active management

Active investing has one obvious attraction – the opportunity to leverage expertise to get a rate of return over and above that of the market. It is for this reason that most people turn to active management and it gets the most press coverage when discussing the merits of active management compared to passive management.But there are number of other reasons that investors choose active exposure. Active management can allow access to markets that are not well served by passive products, such as real estate, infrastructure and other illiquid assets. It can also serve as a useful diversification tool when used in conjunction with relatively concentrated market value weighted indices. Human judgement is also particularly powerful when making complicated judgements concerning long time horizons, such as ESG issues or spotting emerging trends.

Hypothetical rolling 12-month return of investing long in buy rated companies and short in sell rated names. Stocks equal weighted, strong buys and strong sells have been given double weightings vs buys and sells. Source: Fidelity International, May 2018.

Active management certainly has its detractors who most often focus on fees and the difficulty of finding managers who outperform consistently. Fees for active management are coming down but are still usually more expensive than passive products - employing portfolio managers and analysts is expensive after all. But the active management industry is also innovating, introducing variable fee models and quant strategies, to meet investors’ needs better. Broadly speaking, fees increase as you move along the continuum because you are getting an enhanced service which costs more to supply. A singular focus on expense ratios may be missing the point – net return is a better way to analyse the value to investors.It is difficult, but certainly not impossible, to find a good manager who outperforms over a sustained period. Active management tends to do better when markets are inefficient or data is less commoditised. Periods when dispersion is high also give active managers more chance to prove their worth. It is no secret that the recent bull rally in US equities has been incredibly tough for active managers – dispersion has been low and the biggest companies have also largely been the best performers, meaning market indices have been highly concentrated in the top gainers and to outperform an index, active managers would have to own an even higher proportion, introducing concentration risk that would (and probably should) scare investors away.

Broad vs narrow shows MSCI Europe Equal Weight year-on-year total return minus MSCI Europe year-on-year total return markets are broad when above zero and narrow when below zero. Active manager performance calculated from performance of active funds in Europe above respective benchmarks net of fees. Source: Morningstar, Thomson Reuters, Fidelity International, May 2018.
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Source: Thomson Reuters, Fidelity International, May 2018.

There is still value in human judgement

There are also many situations where the nuance of human judgement can add value over and above data that is easily quantifiable. A good example of this is ESG investing. Take e-cigarette manufacturers for instance. Are they good for society because they can help people to stop smoking, or are they bad for society because they normalise nicotine addiction? Then muddy the waters further by considering most of the research into this area is funded by tobacco companies. Do you invest or not? Active managers are also able to meet company management and assess corporate strategy in a way that is still a long way off for even the most advanced computers. Active managers also have an incentive to be engaged shareholders and improve the value of their investments through appropriate stewardship.

Choosing the right mix

Investors are increasingly seeking complete solutions rather than individual strategies. Many see the value in different styles of investing and are looking for a mix to suit their overall investment goals at a particular point in time rather than strict adherence to one particular philosophy.

Choosing the right place on the active-passive continuum is just one of many active decisions investors must make to balance risk, return and cost objectives. Given the variations in performance, diversifying along the continuum, not just among asset classes, might well be appropriate.

However, where to position on the continuum does not need to be set in stone but can be dynamic depending on market cycles and investor needs. The growth in choice along the active-passive continuum is a great step forward in enabling investors to tailor investments to meet their desired outcomes better.

What does the future hold? Expect greater granularity along the continuum as building blocks are broken down and rearranged to create increasingly customised blends of active and passive investing.

This is certainly a good thing for investors as they attempt to meet return targets under fee constraints. What would also help is a more nuanced debate that accepts that, unlike many things in life, the method is not as important as the outcome. Who knows, we might even see better terminology.

Active or passive? Friends or enemies? It’s time to reframe the debate and embrace the whole continuum.

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