Why Active Vs. Passive Is The Wrong Debate

It’s not a binary question but a broad spectrum.

This article is part of a regular series of thought leadership pieces from influential participants in the ETF industry. Today's article features Rick Redding, CEO of the Index Industry Association.

Like nations that have been in disputes for centuries, the “active versus passive” debate is an issue in the investing world that never seems to go away. While the academic underpinnings of the debate prove interesting—and may last forever–do investors even remember the original issue that started the debate?

There are now markets in virtually every asset class, sector, geography and strategy. Rather than debating “active versus passive,” should investors address the underlying assumption of full market efficiency?

Market efficiency theories seem to be tested every few years, especially after downward plunges in financial markets, a rapid increase in commodity value, or after volatility in illiquid markets in very short time intervals. The questions for investors are, what does “active versus passive” mean to them, and are we debating the same original issue?

Investors have disparate views of the terms “active” and “passive.” While some believe it refers to how frequently the underlying index is rebalanced or active portfolio is managed, others historically have said it has to do with how active the approach is to risk management. Active managers may try to lessen exposure when markets seem to get riskier or have a fundamental view on risk, while indexes remain unchanged. I do not believe either viewpoint is correct today, for a number of reasons.

Technology, Innovation And Competition

Technology, innovation and competition have changed the “active versus passive” debate so completely it is hard to appreciate how these elements have affected every aspect of trading and investing.

Not even 15 years ago, the structure of the marketplace was different in almost every respect, with market makers physically located on a trading floor. Now the submillisecond speed in which electronic transactions occur, the access to new markets and trading venues, and the globalization of trading counterparties has made transactional data and the indexes much more transparent and real-time.

Indexes originally were created to be benchmarks, or quick references, of the best representation of a market. Only in the last 40 years has indexing become a driving force in investment product innovation.

We may not fully appreciate how difficult it was to calculate the Dow Jones industrial average by hand at its beginning in 1896. Even in the early years of “index funds,” it took hours to make a simple adjustment to index products without the computational power of the personal computer.

Calculating credit indexes, or multifactor indexes or volatility indexes was not possible. Technology and innovation have made smart beta—or strategy indexes—possible. The competition between index providers, along with investors’ demand for access to new markets, has created interest in a seemingly infinite number of indexes—literally millions. It begs the fundamental question: What role do indexes fulfill today?

Approach

Investors and advisors often jump to the “active versus passive” issue first, when the real focus should be on higher-level issues before implementation. It is important to first spend enough time understanding what we as investors want our investments to do for us and the risk/return trade-off we are willing to accept.

I like to think of investment implementation within an investment continuum. On the far left-hand side of the continuum are traditional market-capitalization indexes, and on the far right-hand of the continuum is active management (see the graph below.)

The issue of “active versus passive” is along that spectrum, as traditional market-capitalization indexes started moving right with style and some factor indexes, while more recently the “smart beta” strategy or thematic indexes have started moving left, down the continuum, becoming more rules-based.

These smart-beta (or strategy) indexes have taken many forms without a common definition or description, making it hard for investors to figure out what smart-beta represents. Some of these strategy indexes are based on algorithms that have frequent rebalancing, while volatility-minimizing indexes may have lower risk than many active portfolios.

Looking at the investment continuum, the two key premises investors use to contemplate ”active versus passive” no longer exist in absolute terms. Rather than continuing this debate, investors should be asking, is “active versus passive” the right way to look at the issue?

Right Questions

From an investment standpoint, there is no simple answer to the “active versus passive” debate. Better answers may lie in discussing investment goals and the best way to achieve them. Or asking:

• What index-tracking fund is being used as a core holding or as a complement to the core portfolio?
• What asset class should I invest in?
• What risks am I taking, and does this increase or decrease the same factors I am already exposed to?
• What is my expected holding time frame?

Only after these and other suitability questions are answered should an advisor or investor try to decide the best way to implement the decisions. Then the answer should look at returns, risks, tax efficiency, fees, holding costs and index or manager selection.

Right Answer

The debate should morph into rules-based indexes versus active management. The innovations in indexes highlight that any asset class or any strategy that can fit into a rules-based methodology can be packaged into a product to achieve investors’ goals.

The ETF market is the perfect example of how the market has used indexes and a product structure to achieve almost any investment idea. Investors should focus on how the underlying index methodology is developed and maintained, as well as the discipline used to maintain the underlying index.

In a transparent, rules-based approach, an advisor or investor is able determine if the index administrator is independent and using best practices to achieve the index’s objective. The only debate remaining for active versus passive investing may be how active or passive investors and advisors will be in understanding the underlying index methodology and/or portfolio strategy.

Rick Redding is CEO of the Index Industry Association.