Just like an auto manufacturer, every advisor wants a client’s investment portfolio to be a well-oiled machine with the right mix of performance and safety features. Last summer, after seeing countless headlines touting increased passive inflows, I found myself with many unanswered questions. Much of what I was reading just wasn’t adding up. Looking for answers, my colleague Mayank Goradia and I embarked on a research project to look under the hood and see what was driving this in the marketplace.
Our first surprise: much of the research we encountered focused on one asset class—U.S. large-cap equity—with the assumption that the results must be true in every other asset class as well. But, was that conclusion justified? We started looking at studies with a cross-asset class perspective, which led us to several imperatives for advisors determining an active/passive investment strategy.
Don’t Compare Apples To Oranges
Most of the studies compared actively managed vehicles to indexes. At first, that methodological decision did not register as a flaw, until I reflected on the finding that actively managed U.S. high-yield funds were underperforming. My initial hypothesis was that these high-yield funds might be in an inefficient asset class and active management likely would do well, but many studies said the opposite. When we took a deeper look, we found that the studies were right: active managers on average did underperform their benchmarks—but so did passively managed vehicles. And, actively managed funds actually outperformed passive funds.
That led to my first takeaway: you cannot invest in an index. So, when you do your own research, it is important to compare actively managed vehicles with investable passive ones, not just with indexes.
Every Asset Class Is Different
For U.S. large-cap equity, the results tend to favor passive investing (more on this later). That being said, for many investment categories, including in fixed income and international equities, the historical outcomes favor active investing. And when you go deeper it appears to be partly explained by structural weaknesses in the index construction that skillful active managers can exploit, helping deliver greater performance for investors.
Fourteen percent of the market cap in the MSCI EM Index is in state-owned enterprises as of July 2018 (for example, energy companies and banks). These could be perennial underperformers, as they may favor government stakeholders more than shareholders. Active managers tend to underweight them, but in a passive vehicle you would be fully invested.
Additionally, fixed income index construction could allow active managers to actually take advantage of changes in the index composition. The rating agencies re-rate bonds every day of the month while bonds are only added or dropped from the benchmark index at month-end. Active managers, though, can buy or sell those bonds before or after they have been included or excluded from an index (and therefore sold or bought by index vehicles).
Those are just two examples that informed my second takeaway: the importance of evaluating each asset class separately.