Among asset allocators, passive investing is often perceived as a safer and more cost-effective option than active management. However, this perception may overstate the benefits of passive investing while ignoring key shortcomings.
Passive strategies generally can offer the lowest fees because the work of security selection is outsourced to the benchmark, and portfolio construction is a largely mechanical exercise that benefits from economies of scale. But fees are only part of an investor’s calculus: Passive investments retain the full measure of market volatility without the prospect of outperformance and, in many cases, are subject to significant structural inefficiencies that originate in the benchmark construction methodology.
Investors may benefit from a more nuanced approach to evaluating passive and active investment strategies. This article summarizes a recent paper exploring key characteristics of both investment styles, with the goal of helping investors better define and differentiate the roles of each.
Is the Benchmark Itself a Good Investment?
To build strategic asset allocations, investors use models whose inputs are the expected returns, volatilities and correlations for each asset class. For stocks and bonds, these inputs are almost always drawn from the same public benchmarks that guide passive investment strategies. This can make a passive investment feel like the default option against which other investments should be judged.
This creates a “burden of proof” for active strategies, which must justify their tracking error to the benchmark with a meaningful level of after-fee performance. That’s all well and good; active managers should be held to a reasonably high standard. What’s often missing, however, is a similar degree of scrutiny with respect to the suitability of the underlying benchmark that forms the basis for a passive investment.
In practice, passive benchmarks vary widely with respect to their suitability. In this regard, three broad characteristics help determine how appropriate a particular benchmark may be as an investment:
- Representation: It should fully represent the targeted opportunity set;
- Methodology: It should follow a logical allocation mechanism; and
- Efficiency: The universe of eligible securities should be free of structural inefficiencies.
If the benchmark does not meet these criteria, then valuing low price and low tracking error may be misguided. Gaining exposure to a poorly constructed benchmark, even at very low fees, is probably an unwise investment decision.
Benchmark Considerations in Equity Markets
Equity benchmarks effectively represent all securities within their market segment. Further, the transparency and liquidity of exchange-traded markets, with one type of common stock for each firm, makes real-time implementation of passive strategies viable—even across broader benchmarks.
Market capitalization is a logical weighting mechanism for individual securities, as it captures the market’s collective evaluation of each firm’s relative value at any given time. It is worth noting, however, that cap-weighting can impart a momentum bias that favors sectors and companies which have experienced positive recent performance.
More critically, historical data suggest that cap-weighting has not consistently outperformed other “mechanical” benchmark methodologies, like equal weighting, across time. Why then, should traditional passive strategies serve as a permanent default option?
Perhaps investors may not feel comfortable timing the market and switching between cap-weighting and equal weighting? If so, an active equity strategy that seeks the best portfolio of underlying securities, without the need to match index weights, may deserve consideration as a permanent choice.
Benchmark Considerations in Fixed-Income Markets
Fixed-income markets present unique obstacles for passive strategies because of the large number of individual securities, as well as the constant turnover as older issues mature and are replaced. Benchmark construction rules narrow the range of eligible securities, which can make the benchmark itself somewhat easier to replicate, but which also leaves significant portions of the opportunity set on the outside.
Compounding the challenge, bonds trade in decentralized “over-the-counter” markets with variable levels of liquidity and price transparency. Building and maintaining a passive portfolio that fully captures all the securities in the benchmark can be costly.
Finally, segmenting markets by credit rating introduces a potentially significant structural inefficiency, because small changes in a security’s credit rating can cause it to move into or out of the benchmark. Many investors—including passive strategies and those with strict regulatory or guideline constraints—simultaneously become forced sellers or buyers at these moments, leading to inefficient clustering of transactions.
Each of these challenges—complexity, illiquidity and structural inefficiency—pose a real impediment to successful passive management. Conversely, they are each sources of opportunity for active managers who can take advantage—of market breadth, pricing inefficiencies and credit migration—to position their portfolios advantageously.
Increasing the Odds of Successful Active Management
Any potential shortcomings of passive investing must be weighed against the challenges of successfully implementing active management. Identifying active managers capable of delivering consistent performance across time requires a disciplined process to evaluate their skill. Quantitative metrics include: historical performance over relevant time horizons; strong information ratios; favorable upside and downside capture; and appropriate fees. More qualitative factors include expertise in top-down macroeconomic analysis and bottom-up fundamental research.
Investors frequently default to passive in certain markets based on blanket assertions that a particular sector is unsuited to active management—often based on the performance of the “average” active manager. For sure, an elevated standard of care is needed to choose active managers in such sectors, but the rewards of identifying a successful active strategy are equally valuable.
In sum, the visible fee savings associated with passive management may have led investors to overlook some of the inefficiencies embedded in the benchmarks—and therefore the portfolios built to mimic them. Active management may not always be superior, but without a thoughtful exploration of the passive strategy’s structural flaws, a fair comparison is impossible. Investors will be well served to apply the same scrutiny on both sides of the active/passive divide.
Jared Gross is the head of institutional portfolio strategy at J.P. Morgan Asset Management.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.
Tags: Active Management, active vs. passive, Jared Gross, JP Morgan Asset Management, passive management