Reflections on Active vs. Passive Management
Online Debates: A Year in Review Part II
BY Jennifer Hughey | May 28, 2010
The second part in this four-part series on the past year in CIR Online Debates, highlights the Active vs. Passive Management debate. Heavy losses during the financial crisis forced many plan sponsors to question the value of their active managers. One of the main queries for debaters was if active management was dead and is a lower cost passive strategy really the answer?
Plan sponsors wondered whether they should give their active managers another chance. What value do active stock pickers add over the long-term? Or would plan sponsors be better off just tracking the index and paying far lower fees?
The pro side was that active management was in fact dead and that active investment analysis quickly becomes a self-defeating process, leaving indexing (passive investing) as the optimum strategy. However, the con felt it was very much alive and if the organization has good governance, consistently adheres to long-term investment horizons and promote an entrepreneurial culture among their employees – that sophisticated institutional investors can “beat the market”.
5 Things We Learned from the Debate
1. Moderator, Leona Fields, manager of the pension fund for York University, opened the debate by confirming the type of management a plan sponsor chooses, depends on a number of factors. It depends on which asset class as some are very efficient and others may provide more opportunity for successful active management. Some questions to ask if you’re a plan sponsor are what is the difference between passive and active fees? How is “successful” active management measured? Are the nature and level of the risks of passive and active management understood? Are performance based fees appropriate and are they more valuable to the investor or the manager? The pro and con reflected on these questions.
2. Pro, Eric Kirzner, John H. Watson Chair in Value Investing with the Joseph L. Rotman School of Management took a finance theory and logic view to support his pro-passive position. Kirzner discussed the efficient markets hypothesis (EMH), which states that security prices reflect all publicly available information – on average, neither over- nor underestimating the true value of securities. This is caused by a set of active investors expending resources to obtain information on companies and trading on this information. The theory implies that you cannot expect to earn excess profits by employing conventional analytic techniques that use information available to everybody. Kirzner says, “If you believe in the EMH, you would believe that the cost of outperforming markets would offset any benefits. The logical extension of the belief is to engage in passive investing or indexing. You’ll be in good company.”
3. Con Zev Frishman, Vice-president of Global Equity Strategies with the Ontario Teachers’ Pension Plan, argued that active investment management is a viable strategy that can add value relative to a passive approach. Frishman noted that the major assumptions underlying the EMH are quite unrealistic. He says that “one has to live in the real world for a short time to notice that investors are far from being truly rational. Agency and behavioural issues, such as worrying about business, legal, regulatory or job risks, often stand in the way of attempting to maximize long-term returns. As investors are human beings, subject to emotional biases; significant research in the field of behavioural finance has shown that investors follow strategies that make them feel comfortable (momentum, chasing “hot stocks”) and get caught up in the hype of bull markets or the panic associated with bear markets.”
4. Guest analyst, Robert Chepelsky, Principal, Morneau Sobeco along with colleague Hubert Lum, researched the active vs. passive debate as it applies to the Canadian fixed income market and found there is little evidence that active management of Canadian bonds has added value over the last 10 years. They found three surprising facts; most active managers fail to beat their passive counterparts; the excess return generated by most managers can be attributed to chance. Over the 10-year period no manager was able to outperform the DEX by enough to statistically show their excess return was due to skill; and risk reduction of active management is negligible and although active bond management reduces the risk of the bond portion of an institutional portfolio, it has little impact on the portfolio as a whole.
5. Comments from plan sponsors and investors brought varying views on both active and passive. One comment from Yong Li, Director of Risk Management and Quantitative Analysis with Dow Chemical Company was about using active or passive investments and how it depends on how much alpha the manager can add on. “On the public equity domain, the alpha for large-cap equity is smaller than small-cap equity. Thus, it makes more sense to do active investment for small-cap equity. On the private equity domain, however, the alpha is much larger than the public side. Thus, for private equity, active investment needs to be deployed. For fixed-income, because of liquidity and pricing issues, passive investment (or indexing) has high tracking error.” Ultimately he and 62% of voters felt that active investment can add more value.
Now Looking Ahead…
Since the economic crisis, the view on active management has certainly changed amongst plan sponsor attitudes. Involving the human element, such as a single manager, co-managers or a team of managers, to manage a fund’s portfolio, it involves a lot of behavioural decision-making skills. Plan sponsors now want to more active themselves, knowing more about the managers’ research, forecasts, judgment and experience in making investment decisions. This is forcing more and more transparency within the industry and making plan sponsors ask more questions about their investment decisions.
Stay tuned for Part III of this series, A Year in Review: Global Equities.