Why Active and Passive Investment Are Not Mutually Exclusive

Last week, Bloomberg penned an article entitled Battered Funds Blame ETFs for Overrunning the Stock Market Again. The article (along with a subsequent Bloomberg sponsored podcast released around the same time) explores how passive investing could be blamed for the underperformance experienced by discretionary fundamental stock-picking managers. For anyone interested, the most recent SPIVA scorecard (as of June 2019) shows that 78.5 percent of large-cap funds in the United States underperformed the S&P 500 over a five-year time horizon. Instead of debating why we think the argument presented in both articles is flawed, we instead want to explore reframing the way people view the active versus passive debate.

We believe the distinction between active and passive should be viewed as a dimmer instead of a light switch. There are no investors (or at least none that we know of) that are truly passive by the academic classification, as asset allocations will always drift somewhat from the theoretical “passive” portfolio. Furthermore, there are investors that use passive products in an active way to carry out their asset allocation decisions, thereby muddying the waters on what assets are truly “passive.”

Despite the fact that the distinction between active versus passive is not black and white, one of the major criticisms from discretionary fundamental managers is that passive investing creates “an underlying bid to the tape that is just there.” To translate, passive investors don’t perform any price discovery, and thus are indifferent to underlying fundamental conditions when they are making investment decisions. We would make the argument that it’s the active managers that are responsible for setting prices (price-makers) and that passive investors are merely price-takers, but because quantitative and indexed investment strategies are systematic, the argument from fundamental managers is one that resonates easily.

The investment management company Tyro Capital released their annual commentary a few weeks ago and highlighted that the advantage of systematic investing is that it’s “actually a better loser” than traditional discretionary fundamental managers. The author posits that quantitative systems are designed so that their systems are consistent and their mistakes (periods of underperformance) are known in advance. This allows those strategies to be proactively evaluated and analyzed so their return and risk profiles are well understood by investors. On the other hand, “discretionary fundamental managers, on average, are the opposite…making mistakes of varying severity, and inconsistently able to capture upside scenarios.” The commentary goes on to suggest that while there are discretionary fundamental manages that add value, the issue for investors is the inconsistent return profile.

Reframing the discussion from how passive investing is distorting the market to one that centers around optimal investor outcomes is an interesting thought experiment. We would opine that the unpredictable nature of fundamental discretionary managers and the inability to consistently outperform a benchmark is one of the major catalysts of performance chasing for retail investors. In 2014, the St. Louis Federal Reserve performed analysis that showed return chasing shaves off up to 2 percent per year from investor performance.

The boogeyman for discretionary fundamental managers might be masquerading as ETF products, but what is really happening is that investors are no longer willing to tolerate unpredictable return profiles (and high fees) for asset classes where beta can be harvested cheaply. Investors are getting more adept at determining whether the “juice is worth the squeeze.”