Active vs Passive Management

After a recent investment/implementation discussion, I decided to do a deep dive on all the recent literature and research around active vs passive management, portfolio construction, rebalancing, and methods in building optimal, risk-adjusted portfolios. As we always are looking to improve our process, I really wanted to understand all of the existing data and apply it to our existing thinking and practices. In reading over 100 published white papers and articles from various investment journals, my take-aways are summarized below (citations included):

The active vs passive debate is better characterized as a comparison of low-fee vs high-fee strategies (and all in-between).
The lowest cost, passive strategies are market-cap weighted and therefore systemically overweight the larger-cap index constituents and heavily exposed to the momentum factor (as an underlying security increases in price the allocation to that security goes up).[i][ii]
The negative press around active management is generally focused on mutual funds, which have an average fee of over 1% in equities category and over .80% in bonds.[iii] Active managers on average outperform their indices before fees and underperform after (average outperformance is 35-50 bps).[iv][v][vi][vii][viii]
Separately managed accounts outperform like mutual funds by ~25-35 bps/year.[ix] Tax-management in active strategies can add additional alpha not available in purely passive strategies.[x][xi]
These results are consistent across equity and bond managers.[xii][xiii][xiv][xv]
Unlike equities, bond ETFs have failed to keep up with their underlying indices due to underperformance during high volume sell-offs. This underperformance can take months to correct and, in some cases, never fully does.[xvi]
There are qualities of active management that have consistently correlated with future outperformance, including:

High Active Share (difference in holdings/weighting from the underlying benchmark).[xvii]
Concentration and a lower number of total holdings.[xviii][xix]
Managers’ personal capital in the strategy/fund.[xx]
Patient investors with longer-term hold periods (average hold of at least two years).[xxi]
Broader mandates and more flexibility in terms of company country, size, and style box.[xxii][xxiii]
History of positive upside to downside capture ratio.[xxiv]

Global equity managers, along with micro/small and emerging market managers, are more likely to outperform than other sub-classes. [xxv][xxvi][xxvii][xxviii] They have also outperformed institutional asset allocators attempting to make the domestic/international/emerging weighting decision.[xxix]
Diversifying amongst factors is more important than style-box (growth/value), size (small/large), or country (domestic/international).[xxx][xxxi]
By combining strategies that meet the above criteria and have different, complementary factor exposures one can create portfolios that are more diversified, have lower risk & volatility, and perform better from an absolute and risk adjusted standpoint.[xxxii][xxxiii][xxxiv]
Consistent with better risk adjusted returns coming from more concentrated managers, research suggests that sufficient diversification can be achieved with 30-50 holdings. Most research agrees that there are diminishing returns beyond 200 securities (some argue that this occurs at lower thresholds).[xxxv][xxxvi][xxxvii][xxxviii]
In terms of initial implementation and deployment of capital, buying into the market based on Z-score moves (standard deviations) reduces volatility and drawdowns but on average hurts total return.[xxxix]
After the initial mean-variance optimization based on desired risk/return, standard asset class volatility bands can set as rebalancing parameters. This linear approach has outperformed traditional rebalancing techniques.[xl][xli][xlii][xliii][xliv][xlv]

Additional Thoughts

Addressing the passive/active discussion, regardless of the underlying vehicle/strategy the advisor/client will have to make allocation and rebalancing choices. For example, the purest passive exposure (a global equity & global bond ETF) still requires an initial allocation decision and that of when/how to rebalance (and when when/how to overweight/underweight if any tactical opinions are expressed). As the allocation gets more granular, choices on the equity side include domestic vs international, small vs large, growth vs value, and/or underlying factor exposure. These decisions exist on the fixed income side, as well as additional considerations like asset class (munis/corporates/MBS/ABS/etc), credit rating and quality, and duration.

Another reason we like global strategies and those with the flexibility and freedom in their mandate is that the decision to overweight/underweight a certain country/style/size/factor is driven by the attractiveness of the underlying investment opportunities, not a mandate or restriction imposed by the allocator.

Our Approach

Consistent with the findings above, we believe that by building portfolios of active strategies that complement each other in terms of investment strategy, style (growth/value), size (small/large), and factor exposure, we can construct globally diversified strategies that give us the best chance to outperform over the long run.

(Example of one of the tools we use to drill down on our strategies’ underlying factors)

By employing this strategy on both the growth and value side of equities as well as muni and corporate bonds we end up with an equity portfolio of ~150-200 names and bond portfolio with ~200 holdings. This puts us as the upper range of what research suggests is optimally diversified (we are OK with the additional risk mitigation).

While past performance is not indicative of future results, when I look at the combined performance of our growth, value, muni, and corporate portfolios over the last 5 & 10 years the results do hold. This is hypothetical as these are the managers we are using today (although most we have been investing with for over 5 years). These reports are below.

As a follow-up and for our next meeting I will be applying the above findings and methodology to your portfolio.

I am around to discuss next week. Talk soon.

Connor

[i]The Performance of Exchange-Traded Funds | The Journal of Alternative Investments (pm-research.com)

[ii]Factor Momentum and the Momentum Factor - EHSANI - 2022 - The Journal of Finance - Wiley Online Library

[iii]Fund Fees’ Continued Decline Is a Win for Investors | Morningstar

[iv]Active Managers Are Skilled by Jonathan Berk, Jules H. van Binsbergen :: SSRN

[v]Measuring Skill in the Mutual Fund Industry by Jonathan Berk, Jules H. van Binsbergen :: SSRN

[vi]Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds by Martijn Cremers, Jon A. Fulkerson, Timothy B. Riley :: SSRN

[vii]fidelityrek051315.pdf (morningstar.com)

[viii]Fund Selection: Sense and Sensibility: Financial Analysts Journal: Vol 78, No 3 (tandfonline.com)

[ix]Tailored versus Mass Produced: Portfolio Managers Concurrently Managing Separately Managed Accounts and Mutual Funds - Chen - 2017 - Financial Review - Wiley Online Library