There is a common misperception that the passive asset manager’s process is entirely algorithm based and requires no skill or decision-making. But, the reality is that passive managers still need to actively make a range of important decisions that will affect the investor’s long-term outcome. These decisions may be different from those made by active asset managers, but are no less important.

Back to basics

Traditionally, passive investing refers to an investment practice aimed at replicating an index as closely as possible by tracking it. A passive investor is happy to earn a return in line with the market – they aim only to gather beta, or simply put, a measurement of relative volatility.

Active investors, on the other hand, aim to outperform the market, hunting for excess returns (alpha).  To do so, they take positions that are not in line with the benchmark, effectively betting that the market is mispricing a particular asset or asset class.

Economic theory suggests that behavioural and structural inefficiencies can create opportunities to hunt for alpha. A successful active manager will spot and exploit these, and consistently deliver results for investors. Their skill in finding such opportunities often means they can command higher compensation. It is therefore widely-accepted that active asset management is more expensive than passive.

Which option is best?  

Trustees often wrestle with the question of whether to entrust their pension fund members’ savings to an active manager who can deliver that much-needed alpha, or to opt for a passive manager who will deliver beta and save on fees. The reality, however, is that both alpha and beta are needed for a balanced outcome.

While some regard index-tracking as an easy, decision-free process, this is not quite the case. The replication of an index is something that requires active trading to minimise the portfolio’s tracking error to the extent that it diverges from the chosen benchmark. Passive managers therefore need to be continuously conscious of the triggers that necessitate rebalancing — including the adjustments made by index providers, any impact of corporate actions, and clients’ liquidity needs.

Successful index trackers anticipate these triggers, and are able to plan low-cost, non-lumpy trades and smoother rebalancing.  It’s true that parts of the process are ‘hands-off’. Timing, pace and size of broker allocations, for instance, may be algorithm-based, but choosing effective low cost brokers, and selecting a model and maintaining it on an ongoing basis, are active processes.

Should passive managers take a view?

Passive investing does not offer a free pass on taking a view. The Steinhoff case provides an excellent example. The omnipotent market became comfortable with the company’s management, with its valuations and its acquisitive practices. The company’s share prices rose, and its size in the market-cap weighted index increased. As the company grew, more index trackers needed to join the convoy to ensure they would still be able to replicate the index. Passive asset managers’ responses therefore exacerbated the market trend.

Amongst active asset managers, who typically take off-benchmark positions, there were those who didn’t hold Steinhoff due to perceived governance concerns.

If a majority of passive asset managers had held the company to a specific standard, a process of natural selection and index-rebalancing could well have eliminated the bad apple. Passive managers therefore cannot afford to be reactive or laissez-faire: Environmental, Social and Governance considerations are no less important in their world, and they can help guide and determine the quality of companies that constitute the index.

Avoiding decisions is not an option

For trustees and individual investors, avoiding decisions when it comes to retirement planning is not an option.  Not making a decision means automatically being invested in a default portfolio, which may not be best suited to your retirement needs. Trustees need to be conscious that allocating to a passive manager is a decision. Their role is no less important than an active manager’s, and it is equally important that they exhibit the necessary skill set. The right blend of ingredients for a healthy retirement can never be the result of inertia or passivity.

Fran Troskie,
Research Analyst, RisCura

*  This article first appeared in Today’s Trustee