The battle is over. The winner has been declared, and the losers are still trying to figure out what happened and what comes next. The unrelenting flow of new money into passive funds would seem to prove that active vs. passive is really no longer a contest. The winner has been crowned.
At CFA Institute we believe that passive funds are an important tool, to be used in their proper place, to help clients achieve active investment management goals. But they are just one tool at an investor's disposal and not the only tool.
Much that has been accepted as fact in this debate deserves closer scrutiny, as other considerations exist that appear to be poorly understood.
1. 100 percent of truly passive funds underperform their benchmark index. Why? Because unless they are taking some type of an active bet or have zero management and administration costs, they have to fall short of their benchmark.
2. Active investors undertake high-cost, high-value activities that benefit passive investors. This results in passive investors paying much lower fees. It’s an uneven playing field.
3. Passive investing wouldn’t make money without some active investing (just how much is enough remains open to debate). Passive investors are essentially free riders, piggybacking off active managers at a fraction of the expense it takes to research investment positions. Few people in this debate focus on this moral hazard—or on whether or not this is fair to active investors, who effectively subsidize their passive brethren. Many question the value of active management but never bother to acknowledge that without it passive investment wouldn’t exist, let alone thrive. Passive investors only make money if markets go up, and active managers move markets.
4. The use of the term “passive” is a misnomer. Every investment decision, including which index and when to index, is an active decision. Incongruent as it may seem, choosing an index in which to invest represents an active decision and comes with responsibility.
5. Telling retail investors to go passive does not equate to financial literacy and furthering investor education. Investing toward particular goals and a more secure future entails much more than buying low-fee index funds. By calling indexation “passive,” we lure clients into a false sense of security. It leads them to conclude that by not “thinking” (being passive) they can achieve their investment goals.
6. A charging bull eventually tires. A 10-year bull market in equities favors passive funds because they have zero cash drag compared with active funds. Yet that very same cash drag becomes a cushion in a bear market. Time will tell what the next 10 years hold.
7. Active managers need to reinvent themselves. Fee and margin compression will bring about consolidation among active managers. They need to focus on providing investment returns that provide solutions to client needs and not the constant chase of growth of assets under management.