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Active and passive - a place for both

April 2017

The merits of active investing over a passive approach is a debate that has rumbled on for decades. The discussions have been thrown sharply back into focus by a combination of changes in the financial market backdrop and increasing regulatory scrutiny.

The endless debate

The active versus passive investment argument is longstanding. Passive investing offers access to a broad, diversified range of investments in a cost-effective way. It aims to achieve average market returns by closely following a chosen index. Rather than outsmart the market, passive investment managers try to match its returns, before fees are deducted.

Active investment managers, meanwhile, may aim to beat the market or a specific target, through in-depth research and analysis of stocks and securities. This should create an information advantage to help generate excess returns, but this added layer of skill comes at a price.

How passive grew aggressive – a historical perspective

Several trends have led to the growing popularity of passive investing, particularly in the last few years. Since the global financial crisis and the onset of quantitative easing (QE), stocks and sectors have become highly correlated and we have seen less discernment by market participants. In such an environment, differences in the quality of earnings between companies are sometimes ignored by equity investors, while default risks for bond investors also become less important. This has made outperformance challenging for active managers and has undoubtedly favoured passive investors – the adage "a rising tide lifts all boats" will not be unfamiliar.

When markets are enjoying positive performance, so too will passive funds. That has certainly been the case over the past few decades, where we have seen a bull-run in bonds and, at times, other risk assets like equities outperforming inflation and generating attractive excess returns. The appeal of passive funds has also been extended by the low interest-rate environment, which has driven yields across asset classes to historically low levels and made investors much more focused on minimising fees to maximise returns.

Regulatory scrutiny has served to further fortify the argument for passive investing. In the UK for example, the Financial Conduct Authority (FCA) published an interim paper on its study of the asset management sector. Its findings focus on the fees charged by active and passive funds and what it believes to be a lack of price competitiveness between active managers; questioning the value for money that investors in active funds are receiving. Conversely, passive funds are credited for their transparency and simplicity.

The FCA's initial findings have come at a critical time for active managers, when many may have struggled to outperform in the wake of the Brexit vote and the election of President Trump. Sector rotations following both events were some of the largest on record and this startlingly aggressive reaction punished the positions of many active managers.

This has been complex terrain for active managers to navigate, but a largely rewarding one for passive investors who have seen their investments rise with the markets. But what happens when this tide turns?

A new dawn for active

We would argue that we are at such an inflection point, where new opportunities for truly authentic active managers are emerging. Since the financial crisis, QE has driven a herd-like mentality where investors have been buying with less concern for value. Now though, as QE looks to be coming to an end and 'Trumponomics' plays out, we expect a more fertile hunting ground for active investment managers, with greater differentiation of returns across asset classes, stocks and sectors.

The current (and potential future) low-return environment could also see passive investors re-examine the merits of an active investment approach, as any additional returns generated above market levels (alpha) will represent a greater proportion of their total return.

As for regulatory scrutiny, truly active managers will welcome the opportunity to differentiate themselves from those claiming to be active, but offering passive-like exposure for higher fees.

Actively adapting

In a market environment characterised by tremendous change and complexity, active investment management remains hugely relevant. Skilled managers will be able to navigate the uncertainty and demonstrate their value by exploiting proprietary insights. In addition, greater polarisation of returns from companies that do well in the new landscape are likely to offer compelling investment opportunities for research-intensive active managers and skilled stock pickers.

We believe investors will increasingly seek a much broader 'new active' opportunity set. This will likely include multi-asset, target-return, unconstrained and enhanced-diversification approaches, as well as emerging market, private market and infrastructure investment opportunities that are not easily replicated in passive funds. Those investment managers committed to broadening and deepening their sources of alpha and developing next-generation investment solutions are positioned to thrive.

The yin and yang of investment?

Undoubtedly, there is a place for both active and passive approaches in a well-diversified portfolio and a combination of both will work well in different market conditions. Therefore, the 'either/or' debate is relatively futile. Of greater importance is whether clients' investment solutions are delivering the outcomes they expect, at a cost with which they are comfortable, and that they are 'actively' benefiting them.

To find out how Aberdeen Standard Capital can support you, please visit www.aberdeenstandardcapital.com or email us at asc@aberdeenstandard.com

Warning

Investment involves risk. - The value of investments, and the income from them, can go down as well as up and an investor may get back less than the amount invested. Past performance is not a guide to future results.