Active and Passive Investing: Navigation Redefined

Executive summary:

Debating the advantages of a GPS versus a paper map is a lot like the ongoing debate between active and passive investing
Each has their place but, in some cases, combining the two provides the best of both worlds
Just as a GPS navigator supplemented with a map provides both real-time guidance and a reliable backup, investors may benefit from the dynamic decision-making of active management alongside the potential stability of passive strategies.

In today’s world, a journey without a GPS is almost unthinkable. These devices efficiently guide us to our destination, alerting us to traffic jams and rerouting us around unexpected obstacles. Yet, sometimes, a simple map proves to be a better tool. While it might not provide real-time updates on traffic, a map offers reliability in areas with poor internet connections or for straightforward trips. Indeed, some people prefer the simplicity and certainty of a paper map.

This dichotomy mirrors the ongoing debate between active and passive investing. Some advocate for the dynamic decision-making of active management, while others champion the stability of passive strategies. However, like navigating with both a GPS and a map, combining the two approaches can offer the best of both worlds.

Just as a GPS navigator analyzes real-time data to recalibrate routes efficiently, active management interprets market conditions to steer portfolios towards investment goals. Meanwhile, passive management, akin to a map, provides a predetermined route based on market indices, offering stability and a reliable foundation.

Potential benefits of active management – the dynamic guidance of a GPS

Alpha – Excess return

Active management seeks to outperform market benchmarks, aiming for what’s known as 'alpha'—the excess return above the benchmark. For investors, the potential for alpha helps assess whether the added cost of active management justifies the expenditure, or if replicating the benchmark at a fraction of the cost is the more appropriate choice for a given investment challenge.

The key lies in identifying inefficient areas of the market where you can uncover opportunities to generate alpha. This takes skill, resources, and a little bit of luck to capitalize on these opportunities. In addition, making active decisions can also be penalized if incorrect. Investors need to decide whether the upside reward potential is worth the downside risk.

Finding alpha

One of the primary potential advantages of active management lies in finding that “diamond in the rough” stock — companies that may be undervalued compared to their fundamentals or peers in the same sector. This is harder to achieve when information about a company, its industry and the overall market dynamic is widely available -- and hence priced into the security. However, the better active management teams, armed with experienced, well-resourced research capabilities, have the potential to identify inefficiencies by scrutinizing company financials, market trends, and industry knowledge to build a portfolio of securities that may hold that elusive alpha potential.

Market segments such as small cap, international and emerging markets tend to exhibit some of those inefficiencies. Professional portfolio managers conducting in-depth research and analysis may have greater opportunity to uncover information that is less accessible and discover anomalies and undervalued companies that might be overlooked when naively following the benchmarks. After all, giants like Apple once started as small caps, and many investment managers who invested early and saw the long-term potential of these companies were able to reward their clients with outsized returns.

Risk mitigation

Another potential benefit of active management is its ability to manage risks. For example, if you own a passive ETF that tracks the S&P 500 Index, it has security concentration risk built into the portfolio. The largest companies in the market, MAMAA stocks, (Meta/Facebook, Apple, Microsoft, Apple, Amazon) comprise approximately 22% of the S&P500 Index, as of March 7th, 2024. If something happened to one of those stocks or the group collectively, it could have a significant impact on the overall portfolio. However, active management has the potential to mitigate this risk and ensure a portfolio is more appropriately diversified across the market universe of opportunities.

Potential benefits of passive management: The reliability of a map

Market tracking and cost

Passive management, much like following a pre-determined route on a map, delivers market-like returns with cost efficiency. According to the 2022 Morningstar Fee Study, actively managed U.S. Large Blend mutual funds charged an average of 0.91% in annual fees, while passively managed U.S. Large Blend mutual funds charged an average of 0.37%. The spread between fees charged on Foreign Large Blend Funds is even greater with active funds averaging 1.04% and passive funds averaging 0.35%. With no potential for upside or downside beyond market returns, passive management could be a viable option in highly efficient market segments where uncovering alpha is challenging. By tracking a market index, passive strategies offer simplicity and consistency.

Navigating the intersection: A balanced approach of active and passive management

While active and passive management each have their merits, blending the two can create a well-rounded investment strategy. Just as a GPS navigator supplemented with a map provides both real-time guidance and a reliable backup, investors may benefit from the dynamic decision-making of active management alongside the potential stability of passive strategies.

By embracing both active and passive approaches, investors can navigate the complexities of the market with confidence, leveraging the strengths of each to achieve their financial goals. Active management can deliver alpha in less-efficient market segments, potentially improving the long-term return of the investment solution, while passive management helps control overall costs while still capturing market returns. This sounds like a winning combination for an evolving investment landscape, just as having both a GPS device and a paper map in your car can help you find your way from Point A to Point B.