Understand Active vs. Passive Investing

In very formal terms “investment” is the purchase of goods that are not consumed immediately but are used to create wealth in the future. In more narrow financial terms investment is the purchase of assets that are expected to deliver profit in the future (either by delivering cash flows or to be sold at higher price). Investments are made by people who have excess liquidity (more cash that they can consume). The capital market is the perfect place where these people can put their excess liquidity to work with purchasing financial assets – stocks and bonds (and other types). It is pretty straightforward process:

We buy stocks now and expect to benefit from their dividends or rise of price. However there are some issues. For example it is estimate in 2019 that there are more than 630 000 publically traded stocks in world[1]. So the main question is which stocks to buy?

Active vs. Passive

After a century of advancements in the field of asset management, most simply there are two main approaches for investment – active and passive management. The line that separates the two types is very blurry. The number and complexity of securities and investment tools are rising every day and the emergence of FinTech leads to this mashing up of definitions.

Traditionally what most people understand from “investing in capital markets” is the active management. The wider definition is that this is a process of trying to select the best assets from all available and put your money into them. More narrow (professional) definition is the selection of assets with the goal to outperform competitors. The vague term “competitors” is usually defined as a benchmark. For example the classic definition of active investing is to buy 10 best stocks (that you believe in) from Singapore, then construct portfolio and hope that at the end of the year this portfolio will have higher return than the market, represented by FTSE Straights Times Index.

It is easy to note that the problem with this approach is “that you believe in” part. It is implied that investors should have some knowledge which are the best stocks. Hence there is risk that this knowledge may be wrong or incomplete. This gives rise to the other major approach – passive investment. The idea of passive investment is the emphasis on preservation of wealth rather than trying to outperform. It is done by investing in the entire market (practically in proxy) and then the faith of your investment is the same as the market. In this case investors are not trying to outperform the market, they are just benefiting from it.

Pro’s and Con’s

Let’s make quick comparison between the two approaches. Given what we figured out thus far here it is quick Pro’s and Con’s table:

The main theme is that active investment gives more control in the hands of the investor: chance for greater returns, risk management tools and others. However it is expensive in terms of both money and time. Choosing best stocks requires either your time and skills in researching information or money to pay someone else to do it.

On the other hand passive investment is effortless and therefore much more cheaper. However with anything cheaper it is valid that it is of less quality. Passive management lacks the ability to avoid market crashes, there is no chance to be superior and it is hard to be flexible.

The comparison between the two approaches is pretty straightforward. However there two finer points in all this:

• The distinction between the two types is blurred. Whether given investment decision is active or passive may depend on the point of view;

• There is misconception about active investing. Active investing can be made cheaper and simple!

Now lets review both of these interesting and not really well-known points, but very important for investors.

This Blurry Line

Rarely there is evident distinction between active and passive management. The line that separates them is whether or not investors rebalance their portfolios with the idea of getting better assets. But in practice who doesn’t want better investments. What if you switch between indices? Therefore something that by definition is passive investment can become active decision. Altogether the discussions arise in three different cases along the border:

Factor Investing

The interbreed between active and passive management is the factor investing. Basically factor investing relies that the market has mispriced certain risk factor and there can be profit from such an anomaly. The classical example is value investing. Historically since Fama and French 1992 paper we know that “value” companies (usually stocks with high E/P) outperform. This can be used by active investors by assigning scores based on the E/P coefficient and selecting the top 10,20 or etc. stocks. However this can be considered also passive investment because once we select our factor we do little to manage it. Factor investing is perhaps the best of both worlds it is relatively cheaper both in terms of time and money and gives the investor opportunity to outperform the market by actively selecting the factors.

Total Return Funds

Total return funds are investment scheme where the goal is to maximize the return. In contrast to the traditional actively managed funds, here comparison against the benchmark play a little role. The rise of these instruments is in response the problem with relative performance. Active fund can beat the market (and manager with get fees for it), but if the market is negative then the total return of the fund might also be negative and thus destroy value to investors. Fundamentally total return funds should be actively managed since it gets the best opportunity to maximize return. However the special case where the market (index) is the best opportunity to achieve highest return can be considered a passive investments.

Market timing

Market timing is the decision when to apply given strategy based on market conditions. It is used both in passive and active management. For active strategies (even successful) current market conditions negate the gains. The same is for passive management: you know you want to invest in the market index but the current conditions have to be taken into consideration and decision may be postponed. Especially interesting is the case of long-term market timing, when we talk in years or even decades. The classical definition of active management does not include such long-term strategies that consist of 5-6 rebalances in the span of a decade. However the goal is to get superior performance by using information and this mean there is active element in it.

In this issue of active vs. passive investment is concentrated the bulk of current investment research. A lot of papers such as Pastor and Staumbaugh (2010), Staumbaugh (2018), Haber (2019), Heaton (2019), Anderson (2017) and others compare the two approaches. However the bottom line is: it depends on what you consider active!

Our view of the issue is based on only one word: information. For ABIR Analytics research team whether or not some investment decision is active depends on if it uses information. If it does use new information we consider it active decisions and should be evaluated accordingly. The reasoning is that by “active” we mean investors that make their decisions when new information arrives. When you invest in the market index and if you decide not to use new information as it arrives then you are passive investor. But if you use this new information to change your views then you become active.

For example lets take the debatable factor investing. You invest accorind to Fama and French methodology and buy the 10 stocks with highest E/P (and get exposure to “value” factor) on given index. But next quarter when the new financial statements are published then the E/P ratio changes and therefore the list of top 10 stocks may be changed and you have to rebalance it to include this new “value” stocks. Thus you become active investor!

Information provides alpha

Obviously for us the key is “information”. By information we mean anything related to stock-specific returns that can tell us which stock(s) are better. For example company A just got a big new contract, or the revenue growth of stock B is higher than expected. In most cases this information is a result of extensive research: financial analysis, equity valuation, deep qualitative research and others. It is important to note the phenomenon that actually all required information is available to everyone, however only a few skilled people can analyze it and turn it into useful information for stock returns. Actually active management is expense because of this phenomenon. The higher fees that investors pay for active funds are not as much for performance, but rather for the ability to process this raw information better. However it turn out that casual and less sophisticated investors can do it themselves. So let see the role of information in investment management. We build our understanding on the well known Capital Asset Pricing Model (CAPM):

Validity of CAPM is one of the bases for passive management. However the key is this residual return (deviations of the consensus return). Active portfolio management methods are applied whenever asset managers deviate from the passive weights in the benchmark in an attempt to capture significant risk-adjusted alpha. The conditions of weak-efficient capital markets allow managers to expect some success, but it is no easy task. In such markets, the unconditional expected alpha is nonexistent, i.e.

For each stock, the time-series expectation of alpha for the next period is zero. In the cross-sectional (CS) dimension, randomly selecting stocks will not yield any sustainable results. Market efficiency imposes this characteristic and it simply says that investors should not expect that some stocks will outperform others; they do not know which stock to be overweighed and which stock to be underweighted in their active portfolios. In other words, they do not know how to construct their portfolio bets.

To tackle this stalemate, active portfolio management theory proposes the existence of the information I that can predict risk-adjusted alpha. From here, the conditional expectation of alpha is no longer equal to zero, as presented in (2).

In this way, managers can make their bets according to the provided information and will get meaningful results. Whether or not these results are positive depends on the quality of the information.

Theoretically there are three types of investors: uninformed, partially informed and fully informed:

Obviously every investor have to choose between the first and third character. Everyone can be active investor. Each one of us is born with the ability to collect and process data about the world, in this case stocks. The tools of active management only help investors to channel this ability and create efficient portfolios with a good care of risk.