The Active Vs. Passive Debate Has Become Rather Tiresome

August 28, 2014

4 minute read

Morningstar got a lot of pushback from readers in the wake of John Rekenthaler’s recent essay that asked a loaded question: “Do Active Funds Have a Future?” His short answer: “Apparently not much.” Unsurprisingly, advocates of active management responded with gales of criticism, triggering a bit of a mea culpa from Rekenthaler, a Morningstar veteran and generally speaking one of the better analysts in the mutual fund game. He writes in a follow-up piece: “Rather than pit active funds against passive funds, I should distinguish between deserving funds and those that are not. I agree.”

Whatever the pros and cons in this debate, arguing over active vs. passive at this late date is a bit tiresome. It’s well established that it’s tough to beat an intelligently designed index fund. If you’re unconvinced of indexing’s edge at this point, you never will be. But for all the light and heat that’s rolled forth on this topic, quite a lot of the debate centers on whether it’s worthwhile to look for talent within an asset class. The classic example: can you identify a manager, in advance, who’s going to beat the S&P 500? A small library of research suggests that the odds are stacked against you (and active managers). But what’s too often lost in this war of words and numbers is the issue of the additional burden that arises when choosing active managers in an asset allocation context.

Imagine that you’ve decided to build a multi-asset class portfolio that invests across the major asset classes. By my reckoning, that adds up to 14 markets. In other words, your task is to choose 14 products. If you go the actively managed route, the workload will be quite heavy. Sorting through active funds in each of the 14 categories and running a battery of tests (factor analysis, for instance) to decide if the results reflect genuine skill that compensates for the higher fee over a comparable index fund is no one’s idea of a picnic. But that’s just the beginning. Over time, you’ll have to spend a lot of effort monitoring the managers in the thankless task of deciding if they continue to show alpha-generating skill. At times, you’ll be convinced that you need a replacement, and the game starts all over again.

Inevitably, you’ll be wrong in some cases, for a variety of reasons. What appears to be skill could just be dumb luck or noise. There’s also the possibility that a manager with a deft hand at picking securities in the past loses his touch. Sometimes managers leave or retire. Even under the best of circumstances, the additional workload of choosing and monitoring a spectrum of active managers is time consuming.

The question is whether a better use of your time is trying to optimize your rebalancing strategy? For most investors (and institutions), the answer is “yes.” Why? Because the lion’s share of results in a diversified portfolio of asset classes through time will come from rebalancing choices. Using index funds frees up a lot of time to focus on what really matters. Intelligently choosing index funds isn’t exactly child’s play, but it’s dramatically easier than sorting through hundreds if not thousands of active portfolios in search of a needle in a haystack.

The notion of spending a lot of research effort and time on the dubious prospect of marginally juicing results by selecting numerous active managers is, well, assuming a lot. That’s not to say that it can’t be done. But we’re talking about odds here, and the odds don’t look promising for picking a series of hot hands that will beat the indexes—after adjusting for the higher fee over a couple of business cycles.

What tends to happen for those who think they can beat the odds is that the resulting portfolio ends up delivering middling results for a relatively high fee. Indeed, even professional asset allocators have a tough time beating a passive, market-value-weighted mix of all the major asset classes, as I’ve discussed previously.

There’s no mystery about what’s going on here. Choosing a set of active managers will almost surely end up with a mix of superior and inferior funds. The net result: middling performance, albeit at a high price. The decision to use index funds isn’t going to deliver better results per se, but the price tag will be lower, perhaps substantially lower. That’s a big deal over time. An index-based asset allocation strategy that costs, say, 25 basis points has a strong edge on an ex ante basis over a portfolio with an expense ratio of 100 basis points that’s populated with active managers.

The bottom line: for the same reason that index funds are tough to beat within an asset class, the same logic applies with asset allocation. Does that mean you should slavishly use index funds and ignore active managers? No, not necessarily. If you have the skill set (and the time) to crunch the numbers, perhaps you can identify talent in advance. But there’s no compelling reason to pre-emptively favor an all-active-manager-based strategy for asset allocation.

Quite a lot of academic and empirical research tell us to emphasize index funds for asset allocation. If you want to flavor that with some carefully chosen active managers, that’s fine. But the law of large numbers (and a deep pool of real-world performance results) strongly suggest that you keep your active bets to a minimum when designing and managing asset allocation strategies. Indeed, designing a strong rebalancing strategy is already hard enough without the additional burden of trolling for talent.