Why the active vs passive debate is a false dichotomy

For years, the debate between active and passive investing has dominated discussions among financial advisers. However, we think this argument is becoming increasingly outdated. The focus should be on active asset allocation which we believe delivers the lion’s share of the portfolio returns. The active versus passive discussion then migrates to the portfolio construction decision as to whether the active asset allocation is implemented using active or passive vehicles.

The active vs passive debate – a stale narrative

We define active investing as a hands-on approach where portfolio managers aim to outperform market indices through security selection market timing versus the underlying indices. Passive investing, on the other hand, seeks to replicate the performance of market indices, often through index funds or ETF. We are starting to see the proliferation of active ETFs where the market and or index that they are looking to replicate requires an element of active management to deliver the desired outcome.

Many investors are keen to highlight the fact many active managers fail to outperform the market over the long term, especially in well researched and efficient markets like this US. And they would be right, passive investments have typically outperformed active ones after accounting for fees. The high costs associated with active management often erode any potential gains, making passive investing more appealing to cost-conscious investors. With the rise of technology and information accessibility, markets have become more efficient. This efficiency makes it increasingly difficult for active managers to consistently outperform the market.

On the other hand, it’s long been said that asset allocation is the main driver of investment returns – roughly 80% of long-term returns come from it. We think investors should be pragmatic towards the active versus passive debate and should consider the entire spectrum of active and passive funds. This decision is fundamentally determined by the investment thesis, whether you are just looking to capture the market directional returns or identify specific ideas within a given market where an active manager will allow you to realise those opportunities.

We continue to like passive funds for low-cost core exposure to core markets and tend to prefer active for more specialist areas. Uncovering stocks or areas that the wider market doesn’t fully appreciate is where active management works best and cost, although important, maybe a second-order consideration here. Often more pivotal to returns is the expertise of the manager and their team in their respective asset class.

In areas such as high yield bonds and emerging market debt, we believe that the value can be driven by security selection, highlighting the need to source the best active managers to achieve the chosen objective as opposed to favouring index products where one picks up unwanted exposures as a function of the market index being inefficient. There are also asset classes that can help to diversify the overall portfolio but are not generally accessible via passive products such as physical infrastructure and real estate.

Strategic Asset Allocation – the future of portfolio management

SAA is a long-term investment strategy (five years) that focuses on setting target allocations for various asset classes and periodically rebalancing the portfolio to maintain these targets. This approach offers several advantages over the traditional active versus passive debate.

SAA has a sharp focus on diversification across the entire investment universe – not just the split between equities and bonds. A simple split between equities and bonds is a one-dimensional approach which won’t protect you from some risks that are out there. To provide a well-rounded portfolio, investors should consider carefully selected investments in areas such as infrastructure, property and alternative strategies to complement core positions and provide diversification opportunities in portfolios.

Additionally, a robust SAA framework allows for a tailored approach based on an investor's risk tolerance, time horizon, and financial objectives. This personalised strategy ensures that the portfolio remains aligned with the investor's long-term goals and is rebalanced regularly. It is essential that any overarching investment prociples are captured at the SAA level as its imperative to ensure that you are building outcomes that are investable for the portfolio.

In the case of our Centralised Investment Process (CIP), we overlay our SAA framework with a dynamic alignment. This is utilised to take advantage of short-term opportunities in the market or to avoid undue risk for the same return. Year on year, it’s unlikely the same asset class will continue to dominate the performance leaderboard, so it’s important to tilt portfolios away from the SAA to take advantage of the variability in market returns and react to an everchanging world.

Read more: Unleashing the benefits of unconstrained asset allocation

The bottom line

The active vs passive debate as an investment strategy irrelevant in the face of evolving market dynamics and a challenging economic backdrop. Central banks in most countries started to cut interest rates, although there were less cuts than predicted. Geopolitical tensions around the world continue to add to uncertainty, as well as President Trump rejoining the White House for a second term, with the threat of tariffs and ensuing potential trade wars.

With so many unknowns, active management is essential as we monitor the knock-on effects to all asset classes. Understanding what is ‘under the hood’ of your investment is vital, whether you are investing in an active fund manager or a passive index fund.

The US equity market is the largest and deepest in the world, giving investors the flexibility to access this dominant economy in a number of ways, such as by style, sector & market capitalisation. This allows our models to manage concentration risks, such as those created by the dominance of the ‘magnificent seven’ which makes up almost a third of the S&P 500 index.

Financial advisers should pivot their focus towards strategic asset allocation, which offers a more robust framework for managing portfolios. By embracing SAA, advisers can better serve their clients, ensuring that their investments are aligned with their long-term financial goals and risk tolerance.

It's time to move beyond the ageing argument and adopt a more forward-thinking approach to portfolio management. In the case of active and passive, however, not only do we think investors can choose both, but the story of passive’s rise and active’s demise has been greatly exaggerated.

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