Why the active game has changed

This essay appeared in Citywire Selector on October 28, 2011.


Beyond answering the question ‘active or passive?’, investors should be asking what is the significance of the ‘active or passive’ debate for today’s quickly evolving investment landscape? Does the question still matter?

Passive means something quite different as broader asset allocation decisions are becoming more and more active. In terms of both timing and types of exposures nothing seems left to passivity – the time for ‘set it and forget it’ has passed.

More significant is the integration of the passive into a broader application of active management. Asset allocation decisions are increasingly part of the manager’s charge.

Narrowly defined ‘bucket products’ with ‘low tracking’ error targets, obsession with risk defined by index weightings and rigid dedication to someone else’s definition of a particular style are on the wane.

The indices themselves are being drawn into question – market cap-weighted exchanged for fundamentally-based, for instance.

Of course, the creators of those indices have their own explaining to do; does that committee at S&P who choose the most representative 500 stocks in the US have as firm a grasp on reality as the guys down the hall who downgraded the country’s credit rating?

Investment banks defining the index constituents with an eye on their own flows and product structuring? But I have digressed.


Times they are a’changin’

The importance of the question ‘active or passive?’ has evolved beyond its original scope.

If you want to identify a real and sustainable change in trends, ask yourself whether the framework for posing the questions about the status quo seems tired. If repeatedly asking the same question yields only a headache and opaque answers (bolstered on either side by data-mined and preordained statistics) then it is likely the world has moved on.

Originally posited offensively by proponents of efficient markets and indexing, the question was intended as an affront to active managers picking stocks. What underlies the significance of the debate is whether the context in which it is applied is still valid.

The issue is not whether active outperforms passive per se, but whether these terms are still reasonable comparables (the question of if they were ever notwithstanding).

I don’t mean to be dismissive of an important issue; questioning whether or not a manager has the ability to outperform a more efficient market exposure vehicle, and is hence worth the fees, is an important responsibility of fiduciary intermediaries. But the system has been uniformly rigged.


New markets require new approach

Built upon the long-cherished strategic asset allocation, it is the ‘set it and forget it’ approach to asset allocation that the market has sucked the confidence right out of since 2008. Stocks and bonds are not performing like they are ‘supposed to’. The dependability of the risk/return assumptions and basic logic underlying the asset allocation are arguably tossed out.

And in the meantime, the uses of passive investment vehicles have become active in new ways.

The mandates being given to asset managers are broadening and include asset allocation decisions as well as security selection. It is part and parcel of the new (old) trend in product development at various scales: global macro, balanced, multi-asset, dynamic asset allocation, total return – call it what you will, it all points to a shift in responsibility for the bigger role of decision making in asset management products. In each case, managers are making active decisions by incorporating passive vehicles; ETFs are the case in point.

So if passive outperforms active but active is buying passive actively and being measured against a broadened passive index, are the returns active or passive? Don’t waste your time…

I am spending a lot of my time these days sorting out just how these ‘products’ fit within the existing asset allocation logic.

I’m also grappling with the implications of the shifting relationship between the entity investing the money and the entity which guides the client decision made through use of a traditional asset allocation modelling approach. There is a lot at stake.