Evolving the Active vs. Passive Debate

Evolving the Active vs. Passive Debate

The active versus passive debate is again in the spotlight as investors shift assets from active strategies to passive exchange-traded funds (ETFs) and products that replicate an index. This reflects the fact that the majority of active strategies have underperformed their passive benchmark indices since the financial crisis.

The move from active to passive is also due to concerns about the level and transparency of fees charged for active management, as well as potential regulatory changes. And this is taking place against the backdrop of an ongoing debate among academics and practitioners around the efficiency of financial markets—proponents of efficient market theory argue for passive approaches, while behaviorists make a compelling case for active strategies.

No Longer Either/Or

We see a few problems with the adversarial “either/or” construct of active versus passive. We view active and passive approaches as complementary, rather than competing, strategies. Achieving financial objectives in general and portfolio construction in particular are complicated problems. We feel it is shortsighted to disregard one or the other and exclude half of the investment tools at your disposal.

Just as important, active management is not just an exercise in beating benchmarks. Rather, we believe active management should be understood as a comprehensive exercise: to provide solutions to clients’ most pressing financial problems.

Additionally, building multi-asset portfolios requires active, purposeful decisions about portfolio construction and asset allocation, as well as manager selection decisions about where to go passive and where to go active.

Cheap and Efficient, but Not Without Risks

Indexing has obvious appeal to the extent that it is a cheap, efficient way to gain access to many markets and realize benchmark-like performance. However, indexing has some limitations—not all markets are effectively or cheaply replicated by an index, and passive approaches in certain markets can also experience high tracking error (not behave as expected) around market crises, or periods when volatility spikes.

Sector Concentration and Risk Increase During Asset Bubbles

In addition, market capitalization-weighted indices carry particular risks related to geographic, sector, industry, and security concentration, particularly during market bubbles.

Technology Sector Impact on the Russell 1000 Growth Index

Sector concentration and risk increase during asset bubbles.
Data from 12/31/1996 to 6/30/2004
Source: FactSet

This chart above reflects the tendency of passive approaches to concentrate in winning stocks or sectors (in this case, the technology sector of the Russell 1000® Growth Index). This tendency helps explain outperformance during rising markets, but also creates downside risks, as shown in the accompanying performance data for each sector. Note that the index’s concentration in the technology sector was at or near its peak when the sell-off was most intense. Passive investors must be mindful of these unintended risks in capitalization-weighted products.

Who Wins? It Depends

Active and passive approaches have historically traded market leadership over time and the analysis of their relative performance is highly end-point sensitive.

Active strategies tend to work best relative to passive during economic downturns, periods of uncertainty, high volatility, and high dispersion of returns. This was particularly evident during the Internet stock bubble and 2007-09 financial crisis, two events often cited by behaviorists in their case against market efficiency. Because risk in passive strategies is always equal to full market risk, we prefer to construct our own asset allocation portfolios using active strategies and a risk-aware approach.

Investors must evaluate the role of active strategies in their larger portfolio and demand value for the fees they pay. Nevertheless, we believe active managers who consistently deploy their unique insights in service of solving a client’s most pressing financial needs can and will continue to thrive.

Read more in the full white paper, “Active and Passive: Complementary, Not Competing, Strategies:” Investment Professionals | Institutional Professionals

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost.

Past performance is no guarantee of future results.

The opinions expressed are those of Victor Zhang and are no guarantee of the future performance of any American Century Investments® fund. This information is for educational purposes only and is not intended as investment advice.