Revisiting the Active/Passive Debate.

Revisiting the Active/Passive Debate


We believe active outperformance results from making investment decisions within the context of a company’s stage of development—rather than in isolation over a short horizon—and supported by differentiated, rigorous fundamental research.

 


KEY TAKEAWAYS

  • Rather than seeing active and passive approaches as mutually exclusive, we view them as complementary—each has utility in certain contexts and roles in an investor’s portfolio.
  • While the market for large-cap U.S. equities is highly efficient and excess returns are comparatively hard to achieve, we believe active investments informed by deep fundamental research and a long holding period can lead to outperformance.
  • We believe active approaches benefit when making investment decisions in the context of a company’s lifecycle. This view contextualizes financial results in a timeline of development, rather than viewing them in isolation.
  • Despite the relative efficiency of the market, we believe persistent behavioral biases and differing investor objectives and horizons create opportunities for active managers to outperform.
  • Academic research supports the notion that active approaches have historically tended to do well relative to passive when concentration is high, turnover is low and holding periods are long.
  • Active U.S. equity strategies have historically performed better in periods when market volatility is high and correlations among individual stocks are low.

 

Not Either/Or, but Both

The active/passive debate is in the headlines again following the stock market’s remarkable 2020 bear market and recovery to new highs. Each side in the debate cites evidence for the superiority of its approach. That shouldn’t be too surprising—relative performance tends to be episodic, so it makes sense that leadership should change along with economic and market conditions. And given the depth and breadth of global financial markets, true believers are likely to be able to find evidence supporting their view sometime, somewhere.

But we aren’t convinced this confrontational, either/or approach is the right way to view the challenge. It’s not a case of “Tastes great!” or “Less filling!”—you really can have both. Similarly, our view is that active and passive strategies aren’t mutually exclusive; rather, they can complement one another in an investor’s portfolio.

As a result, we don’t think investors should be focused on choosing active or passive, but which approaches are most appropriate for their total portfolio needs. Understanding and contextualizing the performance objectives and contours of both active and passive strategies make for more informed portfolio allocation decisions. And we hope this exercise reduces investors’ temptation to try to time or trade between the two approaches.

Persistent Behavioral Biases May Create Opportunities for Active Outperformance

We believe market participants’ behavioral biases create a window of opportunity for active investors to capture excess returns resulting from company- and sector-specific business changes. We believe many investors fail to fully discount improving/deteriorating business fundamentals. In addition, client and regulatory constraints may impede the efficiency of capital markets. We see the following issues:

Market overemphasis on short-term results may create opportunities for investors playing the long game.

We care about performance in the short term, but not at the expense of the long term. We believe investors should view short-term events and news in the context of a broader, long-term assessment of the company in question. But there’s clearly a pronounced focus on short-term results by certain investors that can result in higher volatility and produce excessive fear of deviating too far from peers and/or benchmarks even over relatively short horizons. We believe this can create attractive opportunities for investors who are able to tolerate short-term volatility and hold investments over a longer horizon.

Financial results must be viewed in the context of a company’s stage of development.

Not only do we think the market overemphasizes short-term results, but we believe there’s a broad failure to contextualize those results in a company’s stage of development. For background, a company’s life cycle contains multiple stages, including an initial investment stage, a growth phase, a maturation period, and finally a period of decline. Measures of financial performance cannot be viewed in the same way for companies at different stages in the corporate life cycle. For example, consider a company in its initial investment stage. We would expect an early-stage company should exhibit zero (if not negative) to low profitability because revenues and business expansion have not caught up with capital investment. Similarly, a company in its growth phase should demonstrate profitability below full maturity. Finally, we would expect to see companies achieve profitability targets at maturity when they reach “critical mass.”

The nature of passive strategies creates exploitable inefficiencies.

Passive approaches look to broad market indexes as efficient in the pricing of capital. This leaves the price discovery of individual securities to active managers. Meanwhile, capitalization-weighted indexes rebalance infrequently and rely on market determination of a security’s attractiveness after the fact. This has led to criticism that index-replicating approaches necessarily “buy high and sell low.”1 For example, stocks typically enjoy sustained success before they are added to an index and deleted only after appreciable losses.

Further Principles for Active Managers to Live by

We believe investors can earn superior risk-adjusted returns over time, with the following caveats:

Conviction matters … a lot.

Investors can’t expect to generate excess returns without taking risks and exposures different from a passive benchmark. But there are a limited number of companies capable of generating superior growth relative to the market over time. We believe it follows that we must concentrate our investments in these companies in an effort to generate excess returns.

Deep, fundamental research with a long horizon is critical to investment success.

We believe active managers using rigorous and differentiated fundamental research can more accurately assess a company’s competitive position and growth prospects relative to typical Wall Street analyst coverage. Further, much of this analyst coverage tends to be conservative and short-term oriented. Using these insights into a company’s business prospects, we believe investors can help generate superior returns over market benchmarks and passive approaches by thinking long term during short-term market disruptions.

Academic research finds that active approaches have outperformed passive when concentration is high, turnover is low and holding periods are long.

Seminal academic research supports our view that active approaches using these techniques outperform when they result in portfolios with specific characteristics and contours. Specifically, we believe superior asset managers tend to share these characteristics:

Active managers that do better typically limit fees and trading costs.

Management fees are a straightforward predictor of portfolio performance—investors pay fees, so the larger the fee, the higher the hurdle active managers face in providing returns above those of their passive peers. In addition, active managers must account for trading costs and other expenses associated with executing their strategy.2 We believe based on this research that strategies using a patient, long-term approach with comparatively modest fees and trading activity are better positioned relative to passive approaches.

Low turnover and longer holding periods are associated with outperformance.

Above-average holding periods have been associated with outperformance in several studies. One recent examination of this phenomenon showed stocks held by long-horizon funds outperform, and further, a positive relationship between fund performance and the holding period.3 Of course, we should point out that this relationship is an intended outcome of an investment philosophy and process that emphasizes precisely these characteristics—long holding periods in isolation are not the cause of outperformance.

Recent research on portfolio turnover paints a similar picture, where less turnover and longer holding periods are beneficial. Quoting a 2017 paper on the subject, the authors conclude, “Managers who frequently churn their portfolios underperform both in the short-term and long-term compared to … managers who change their portfolios less frequently.”4

Concentrating around “best ideas” improves odds of outperformance.

A body of research supports the notion that a manager’s highest conviction positions outperform the market and even other positions in their own portfolio. The implication is that “investors would benefit if managers held more concentrated portfolios.”5 Related work by the CFA Institute details where active managers derive alpha. They find that outperformance comes from “high-conviction overweights” or “best ideas.”6 This makes intuitive sense—in our own portfolios, concentration is a consequence of the scarcity of companies with a high probability of outperforming the market over time. When we identify a compelling investment, we take a position of meaningful size in an effort to impact portfolio returns, balanced by such considerations as liquidity constraints and other risk exposures.

Market conditions matter, too: Active has historically tended to outperform when volatility is high and correlations are low.

The recent bear market highlighted the performance advantages of active strategies in down markets. The literature on the topic is deep, and findings vary depending on the period and market. For example, robust academic research points to U.S. equity strategies’ active outperformance during market downturns, periods of economic recession, high volatility, high dispersion of returns and low correlation between individual securities.7 Data for non-U.S. markets are less clear, with results varying by country and market segment.8

Recent work by mutual fund data provider Lipper Inc. supports our arguments that the relative outperformance of active and passive strategies is episodic, and that they should be viewed as complementary approaches.9 The author writes, “For years we have shown that investors have added incremental returns to their portfolios by using a combination of actively and passively managed funds. During periods of strong upward moves in the market, passively managed funds have had an advantage over actively managed funds, while during periods of increased volatility and sector rotation, actively managed funds have edged out their passively managed brethren.”

We Believe the Right Mix of Active and Passive Strategies Can Deliver Outperformance Long Term

Investing isn’t a passive exercise—investors must make a series of active decisions about managing risk and return and precisely where they hope to land on the efficient frontier. The reality is that the modern financial world offers a dizzying array of investment options and approaches, and numerous vehicles to access those strategies. Given this vast palate at investors’ disposal, it seems short-sighted and self-limiting to argue that one type of approach or one single strategy is superior to all others.

The optimal mix of assets will vary from investor to investor, but our sense is that it likely includes both active and passive strategies. But which active strategies? Intuition, experience and a significant body of academic literature suggest concentration, holding period/low turnover and other characteristics such as modest fees all contribute to active outperformance. Just as certain characteristics argue for active over passive, so, too, do certain market conditions—active is preferred over passive when market volatility is high and correlations are low.

Ultimately, we believe that a long-term management approach based on deep fundamental research can deliver outperformance, particularly when those insights are viewed in the context of a company’s stage of development.


1 Rob Arnott, Vitali Kalesnik and Lillian Wu, “Buy High and Sell Low with Index Funds!,” Research Affiliates, June 2018. https://www.researchaffiliates.com/en_us/publications/articles/674-buy-high-and-sell-low-with-index-funds.html.

2 John Chalmers, Roger M. Edelen, and Gregory B. Kadlec, “An Analysis of Mutual Fund Trading Costs,” November 23,1999. Available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=195849.
The authors conclude that “trading costs, like expense ratios, are negatively related to fund returns.” Further, they found “no evidence that on average trading costs are recovered in higher gross fund returns.”

3 Chunhua Lan, Fabio Moneta, and Russ Wermers, “Mutual Fund Investment Horizon and Performance,” CFR Working Paper 15-06, 2015.

4 Claudia Champagne, Aymen Karoui, and Saurin Patel, “Portfolio Turnover Activity and Mutual Fund Performance,” October 2, 2017. Available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2728689.

5 Randolph B. Cohen, Christopher Polk, and Bernhard Silli, “Best Ideas,” May 1, 2010. https://www.lse.ac.uk/Events/Events-Assets/PDF/2017/2017-LT01/20110224-Christopher-Polk-Best-Ideas.pdf.

6 Alexey Panchekha, “The Active Manager Paradox: High-Conviction Overweight Positions,” Enterprising Investor, CFA Institute, October 3, 2019. https://blogs.cfainstitute.org/investor/2019/10/03/the-active-manager-paradox-high-conviction-overweight-positions/.

7 Janis Zvingells, “Active vs. Passive Asset Management: Investigation of the Asset Class and Manager Selection Decisions,” Envestnet PMC, January 17, 2014. https://www.investpmc.com/insights/white-papers/active-vs-passive-asset-management-investigation-asset-class-and-manager.
There’s a mountain of research on the topic, but this white paper provides a solid summary.

8 Fink, Raatz, and Weigert. Do Mutual Funds Outperform During Recessions? International (Counter-)Evidence, 2015.
A good representative counterargument focused on select non-U.S. markets.

9 Tom Roseen, “The Debate Goes On: Active vs Passive,” Lipper Alpha Insight, May 1, 2020. https://lipperalpha.refinitiv.com/2020/05/the-debate-goes-on-active-vs-passive/.

Material presented has been derived from industry sources considered to be reliable, but their accuracy and completeness cannot be guaranteed. Past performance is no guarantee of future results. This information is not intended to serve as investment advice.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

Diversification does not assure a profit nor does it protect against loss of principal.

International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

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