October 26, 2021

Why Bother With Active Management When Mechanistic Passive Does Best Historically?

You want a helping of alpha along with beta-hugging index funds? We asked some shrewd allocators how they get it.

Reported by Larry Light

Art by Woshibai

Passive investing has a lot going for it: index funds’ lower fees, a close alignment to market trends, and the difficulty of beating the S&P 500 and other benchmarks. But if allocators want alpha—outdoing benchmark returns—they need to go out on the old risk curve. Whether they run the assets internally or via outside managers, picking investments is not for the faint of heart.

What are the best ways of successfully implementing active investing? We asked several canny asset allocators how they do this. “You have to be active where risk is rewarded,” said Alison Romano, deputy CIO of the Florida State Board of Administration (SBA), in a recent appearance at our webinar on active management. The SBA has 65% of its portfolio actively managed. For the Florida program, that means much of its US stocks exposure is in indexes, but the majority of its overseas equity and fixed-income allocation is actively run.

To Marcus Frampton, CIO of the Alaska Permanent Fund Corporation (APFC) and the other webinar participant, rough market conditions are ideal times for an active orientation. With some 70% in the active arena, his fund outpaced benchmarks by 7 percentage points in fraught 2020. “You find alpha in the poor years,” he said.

Beating the market is no mean feat, however. A sobering 78% of small-cap and 76% of mid-cap active mutual funds were unable to best their benchmarks for the 12 months ending June 30, as 58% of large-caps fell short, S&P Global found. This demonstrates the peril involved in picking investments. Burton Malkiel, the Princeton economist and arguably the founding father of index investing, said last year that the market’s gyrations made active investing an absurd exercise—therefore, putting your money in an index vehicle is more sensible.

Face it: Following an index doesn’t involve a lot of expensive due diligence. Selecting good managers sure does. And the exercise is about more than looking at past performances.

When assessing outside managers, Paul Colonna, president and CIO of Lockheed Martin Investment Management Company, looks for “stability in the process.” Does the manager have a consistent thesis? “We don’t want to see any pivots,” he said. Does the outside firm have turnover? Has it been acquired by someone else? Colonna and his team evaluate their outside managers every quarter, using a red, yellow, and green rating. Nevertheless, he understands “that no one bats a thousand.” And, he added, “We like a manager who can grow a bit.”

The active-passive dynamic, for pension funds and other asset allocators, is best seen in equity and fixed income. The other investment sectors, known as alternative investments or alts, are by definition actively managed. Private equity, hedge funds, real estate, and the like are investments that someone has to choose. And, of course, it’s rare to find any institutions that are exclusively active or passive.

Which Does Best, Anyway?

No systematic study is available to see how well institutional portfolios with mostly active management do compared with those tilted toward passive constructions. Instead, let’s compare two giant US asset allocators, each known for its preferences vis-à-vis the active-passive dichotomy. For passive, the exemplar is the largest US pension program, the California Public Employees’ Retirement System (CalPERS), which has about 70% of its liquid securities passively managed. For active, the Florida SBA, with around the same portion in the active category. CalPERS is the nation’s largest public retirement fund, with nearly $490 billion at last count, and SBA is the fifth biggest, at $254 billion.

Which has done better? On the surface, it looks like the Florida program. CalPERS logged a decent 21.3% return in the fiscal year 2021, ending June 30. Over the past five years, the California plan averaged 10.3% annually. Florida SBA posted a higher performance for the most recent fiscal year, 29.4%, and was ahead over the past five years, 11.9%.

Does this prove that active skunks passive? In fairness, no. One would need a massive study of all US pension funds. And any number of other factors, such as new capital contributed by the fund sponsor, could have skewed the results for CalPERS and Florida SBA. And CalPERS’ results are pretty darn good.

Still, the mere fact that alpha is attainable with the right strategy, not to mention the right outside managers, is a sufficient enticement for a number of allocators. That involves some value plays, said SBA’s Romano. In pandemic-thwacked 2020, she noticed that real estate got clobbered, particularly real estate investment trusts (REITs), pools that hold bundles of properties. “So we added to our active REIT managers,” she recounted. Smart move. The FTSE Nareit All Equity REITs index, which plunged 12% in 2020, has logged a 27.3% advance thus far this year.

By the same token, savvy value investing increasingly involves deep analytics. “You need to add quality to the mix,” Romano advised. “The evolution of value has expanded beyond simple price to book value.”

The Great Passive-Active Divide

Investing in active or passive is a matter of degree. CalPERS is 67% passive, joined by the California State Teachers’ Retirement System (CalSTRS) at 69% and the New York State Common Retirement Fund at 86%. On the other hand, preferring an active orientation are the Florida SBA at 65%, and the New York City Employees’ Retirement System (NYCERS) at 60%.

College endowments are more heavily into active management. “Very few have passive exposure,” said Larry Kochard, CIO of Makena Capital Management, who previously was investment chief at the University of Virginia Investment Management Company (UVIMCO). For the fiscal year ending June 30, the mostly active UVA endowment equities logged a 51.4% return, slightly higher than the overall fund (49%).

As a rule of thumb, large-cap stocks tend to receive the index treatment, while areas that get less attention—and thus require more research—are the province of active management. Hence, Bob Jacksha, CIO of the New Mexico Educational Retirement Board (NMERB), prefers an active strategy for small-cap stocks in EAFE nations (Europe, Australasia, Far East), as well as in emerging markets. “The right approach for us is to employ an index for the S&P 500,” instead of cherry-picking through this large-cap benchmark, he added.

That sentiment is widespread. “Delivering alpha is diminished for US equities, where it’s very competitive,” said Sean Kurian, Conning’s head of institutional solutions. Domestic bonds, on the other hand, often require a boatload of research to find winners. “They’re not homogenized, and you still need skill to deliver them.” He pointed to the long histories of many debt issues and the panoply of covenants and other features they carry. “Some are secured, some are not, for instance.”

Passive has indeed been on the march, with CalPERS leading the parade. In late 2019, it fired a bunch of external active money managers and transferred $14 billion into internally managed index funds. The fund’s CIO at the time, Ben Meng, said he was tired of index returns beating his active investments. To be sure, despite active stocks making up a small portion of the CalPERS portfolio, they outperformed indexes in the 12 months ending June 30, 46.5% to 41.9%, a recent report shows. But over the longer term, 10 years, indexes were ahead, 10.8% to 10.0%.

Active management actually has attracted court challenges, such as the action against the University of Colorado’s foundation, charging, among other things, that its fee-laden active management had held back performance and index funds could’ve done better. Last year, a judge threw out the lawsuit from a donor and three alumni. This year, another suit was filed against auto parts maker GKN North America Services. It asserts that the company’s retirement program relied on a high-fees active strategy, when an index or target-date fund (TDF) would have served beneficiaries better. GKN is not commenting on the suit.

There’s active management and there’s truly active management. Some active managers are superb at it, others not so much. The average number of outside managers more than doubled for public programs between 2006 and 2018, to 55, a 2020 study by Boston College’s Center for Retirement Research (CRR) discovered. The report also concluded that, unsurprisingly, plans’ fee payouts escalated as they added external managers. Did all this extra firepower pay off for the plans? Nope. On average, those outsider-hwavy returns didn’t produce bonanzas.

CalSTRS CIO Chris Ailman thinks active managers seldom deliver outsized performance, in part due to their high fees. “Over a year, three years, five years, even a 10-year time period, we seldom saw managers consistently add value net of fees,” he told CNBC this summer.

The popularity of active or passive runs in cycles. For the past 10 years, amid a roaring bull market, passive has romped, as good performance seemed a can’t-miss proposition for investors on auto-pilot, noted Mike Hunstad, Northern Trust Asset Management’s head of quantitative strategies. Low interest rates, which have had a salubrious effect on tech stocks in particular, are a key part of this phenomenon, Hunstad said. But that likely will change. And at some juncture, he contended, “we will be at an inflection point.”