CIO View: Active vs Passive

What this debate really hinges on, is time. The active versus passive debate is never going to be settled one way or another, because both strategies have their merits in different times, and in different areas of the market.

Why is that? Well the first thing to clarify is that a passive, market cap-weighted index investment, is not a completely diversified strategy. It’s your low intervention, low transaction fee strategy, and because your money grows with the winners, it is highly momentum driven. Now there are moments when that’s a good approach, as indeed has been the case over the last decade, and there are times when a more selective approach is both less risky, and more attractive.

So, when don’t you want to be in a momentum seeking strategy? The answer is, when you reach a turning point; when valuations get to extremes, indices become distorted and concentrated, and expensive at the top, that’s when you want to be active. And that’s where we are now, not just in the S&P 500, but broadly across global equity markets. As such, we are positioning portfolios towards a greater share of active exposure.

The second thing to think about is where you’re investing. The tried and tested formula is that you want to be active in areas of the market that are less efficient; where there might be fewer analysts covering the stocks or more retail investors than professional investors. That gives you a greater chance of finding undiscovered fundamentals, or differences that will drive returns. A good example of this in our portfolios at the moment is China; after a lengthy piece of research at the tail end of last year we decided to add exposure to China A shares across our portfolios, and we went with an active manager because it is a relatively inefficient market. China A shares have done extremely well since, but our active manager has added about 10% in excess returns over and above the performance of the market. A passive approach would still have produced a positive result, but active had the edge.

In more efficient markets you can also look at options beyond market cap weighted passive investing; you can have systematic exposure, where your investments passively follow specific factors such as quality, value, or any number of metrics. One live example of this for us at the moment would be in value equities. Right now, we are at an extreme point in the undervaluation of cheap stocks. We are taking advantage of this broad-based mispricing by finding systematic ways to capture value across a large number of stocks. But equally, we’re also adding more exposure to a fundamental active value manager because there are so many stock specific opportunities to capture and add even more value, at this moment of maximum dispersion.

It’s important to note that this is not a fixed dynamic. For example, if we looked back to late 2006, value stocks looked unattractive relative to their growth counterparts, and equally, even stocks themselves can move between being considered value or growth. Apple is a classic example of this, right now it’s expensive, but if you look back to 2015, 2016 and even the end of 2018 it was quite cheap on a relative basis. The bottom line is that you need to be dynamic and willing to adapt your strategies according to different market regimes. We would never simply say that active is better than passive, or value superior to growth, because they all play a role at different times and in different ways. The vital task of the long term investor is to be forward looking enough to try and see a regime change when it is coming, and position yourself on the right side of it. We think there is a very high probability, in these extraordinary times, that the next decade will not look like the last.

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