Active v passive: It’s not what you do, it’s the way that you do it

Let’s cut to the chase. After decades of 'you’re wrong, I’m right' finger-wagging and reams of self-serving commissioned academic papers from the more partisan camps, it seems a consensus now accepts that active and passive management is a unity of opposites.

In plain English, both work, and there is merit in using both strategies within a balanced and diverse investment portfolio.

A pension trustee’s primary duty is to act in the best interests of members, providing and protecting retirement income.

As this becomes increasingly challenging, focus on performance and cost is now central to the overall decision-making process.

For schemes not fortunate enough to afford in-house investment specialists, fund managers fill the role.

Whether passive or actively led, for the manager it is all about inflows and total assets under management. The more you have, the better life is.

A cyclical argument

Where the objectives of pension trustees and fund managers intersect has depended historically on where we are in the cyclical debate of active versus passive management.

The fact we have a popularity cycle in this debate illustrates neither method is convincingly more effective than the other.

Indeed it is clear you cannot have one without the other. If all investment was passive, there would be no market and no alpha.

One of the reasons so many passive funds outperform active equivalents is that active funds are managed by people who make mistakes or see their strategies go awry.

Passive and active investing are interrelated and the best strategy is to use both when appropriate, filtering out the market noise advocating one at the expense of the other.

Trustees must work to understand how to use both strategies to fulfil their fiduciary duties and achieve the best performance for the lowest cost.

Big data is everywhere, and yet in one of the most information-driven industries it remains extremely difficult for trustees to make objective decisions.

The key variables here are financial markets.

Beyond regulation and supposed transparency of pricing, ‘market forces’ and that good old intangible human nature determine value.

The end result is subjectivity and innumerable interpretations of the same data.

Strategy implementation

The good news is lowering costs and improving performance are not wholly dependent on choosing the right strategy.

For a moment put aside active, passive, smart beta, factor investing or even dart-throwing.

They all have one thing in common: implementation, or how they are delivered to the end investor.

Implementation is the oft-overlooked and undoubtedly less sexy part of the investment process, but that may be about to change.

The dual pressures of increased regulation on fund costs and transaction cost transparency, together with more discerning and sophisticated investors, are driving innovation here.

No more enforced switching to worse-performing funds because they are cheaper, or moving wholesale into trackers.

Trustees can now embrace both active and passive strategies without limitation.

By removing the performance drag of cumbersome implementation – for example by indexing active strategies – trustees can lower costs and free up performance for the beneficiaries. 

Pension schemes in aggregate control a significant portion of UK assets under management and are under immense pressure to effect change.

It is in asset managers’ collective interests to work symbiotically with the pension industry to create much greater efficiencies in the delivery of active and passive strategies to investors.

James d’Ath is a director at Indexx Markets