a subsidiary of Purpose Investments Inc.

Active versus Passive Investment

Every investor seems well aware of the on-going debate of active versus passive investment management. ETF and index fund firms have strongly suggested that investors should view active managers as a group as both imprudent and expensive. Active managers are pushing back by suggesting that the trend toward passive investments is speculatively skewing the market.

Most of RBA’s investment portfolios mix active and passive investing (i.e., Pactive® investing), so accordingly we think both active and passive investments have something to offer investors. However, the current debate seems to ignore some important questions.

  • Why have so many active managers underperformed? Is all active management bad?
  • How does one know which passive portfolio (or even active portfolio) to buy and when?

Why have so many active managers underperformed?

Is all active management bad?

Past research (including our own) highlights that active management typically underperforms when market leadership narrows (i.e., fewer stocks outperform the benchmark). A few potential reasons help to explain this phenomenon:

  1. Narrow markets conflict with fiduciary responsibility. Narrow markets imply a tighter concentration of stocks outperforms the overall market index. If managers of broad portfolios similarly concentrated portfolios, they could be chided for not following prudent diversification principles. For example, managers who focused portfolios on the narrow technology leadership during the technology bubble were subsequently considered foolish once the bubble deflated.
  2. Broader markets aid those without skill. If one assumes that active managers have no skill whatsoever, then the simple probability of picking an outperforming stock goes up as markets broaden. If 60% of a benchmark’s constituent stocks outperformed the benchmark, a naïve manager would have a 60% probability of picking an outperforming stock. The probability of outperforming under that scenario would be higher than if only 40% of the benchmark outperformed. Because all managers’ skills cannot be above average, broader markets should improve active management performance.

 

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Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments [and the portfolio manager] believe to be reasonable assumptions, Purpose Investments [and the portfolio manager] cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

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