Active Versus Passive Management

By Modern Wealth Management

November 4, 2019

Active Versus Passive Management: Is Active Management Dead?

The active versus passive management debate has been with us for a long time, going back almost to the issuance of the first ETF in the U.S. in 1993. When they were first issued, ETFs were used almost exclusively by institutional investors to execute sophisticated trading strategies. However, it wasn’t long until financial advisors, and individual investors took to them as well.

Broad acceptance came slowly, though, as it took till 2003 for the ETF market to hit 200 billion dollars. 2007 was the peak year for ETF creation and saw the introduction of 269 ETF’s. Then, on December 9, 2010, 17 years after the first ETF debuted, ETF’s reached their first trillion dollars in assets. An article from Index Universe posted on the NASDAQ website on December 15, 2010, indicated that, at that time, only 15% of retail investors used ETFs. They also noted that the $1 trillion in ETFs paled in comparison to the $11.5 trillion in mutual funds, but opined that there were “incipient signs” that ETF’s were stealing market share from mutual funds. The active versus passive management battle was officially on. 

Active Versus Passive Management: Defining the Two 

Active management

In its simplest form, active management is when a manager uses his or her perceived skill, research, intuition, experience, and analysis to pick a group of investments they believe will outperform a benchmark; usually, a market index of some kind. An active portfolio manager must pay attention to a lot of different things to accomplish their goal of outperformance. They must monitor not only the health of the companies whose stock they own, but also market trends, economic shifts, and political conditions both here and abroad. As you might imagine, this usually requires a team of talented individuals in several disciplines. This accounts for the generally higher fees associated with actively managed funds. Typically, active management is the domain of mutual fund managers, and for this discussion, we’ll be referring to mutual funds when we talk about active management.

Passive management:

Passive management is when a manager attempts to create a portfolio that mirrors a market index or benchmark. They select their holdings based on the companies listed on the index, in the same weighting, and hope to generate a return that is equal to the index they’re mirroring. Since the goal of a passive management strategy is to replicate an index, there is no need for a large team of experts and is why pricing is far lower than active management strategies. Passive management is typically the domain of ETFs, and for this discussion, we’ll be referring to ETFs when we talk about passive management. 

Active Versus Passive Management: The Day they Became Equal

On May 17, 2019, Institutional Investor posted an article by Julie Segal titled History Made: U.S. Passive AUM Matches Active for First Time. She notes that at the end of April 2019, assets in passive domestic stock funds had grown to 4.3 trillion dollars, which was equal to the amount held by active managers. Segal notes it’s not a surprise the active versus passive management battle had reached a tie in the U.S. stock fund realm after the perceived failure of active managers during the 18-month-long Great Recession that began in the fall 2007 and ended in the spring of 2009.

She asserts that investors lost faith in the financial industry in general and in active managers’ abilities to protect them from deep market routs and that their “tastes seemed to permanently change.” And you can’t blame her for thinking that to be the case. Her article contained an infographic that appears to have come from Morningstar titled Passive Goes Massive. The infographic clearly shows the switch from active to passive management over the 20 years from December 31, 1998, to April 30, 2019. In 1998, 35.8% of assets in U.S. equity funds were in actively managed large growth mutual funds. By 2019, that number had dwindled to 17% while passively managed ETFs accounted for 33% of all the large blend investment assets. But that’s just part of the story.

Active versus Passive Management: Cyclical Nature and Fickle Investors

In the article Active Investing is Dead, Long Live Active Investing published by Daniel Goldman on March 20, 2019, Goldman notes the cyclical nature of investing disciplines and how active versus passive management is a debate that’ll likely last longer than most think possible. He cites a white paper published by Hartford Funds (obviously someone on the active management spectrum) that lays out how cyclical active and passive investing can be. One is never king for long. 

Consider this:

From 2000 to 2009, active management outperformed passive management 9 out of 10 times. But during the decade before that, passive outperformed active 7 out of 10 times. 

And over the past 31 years, active has outperformed passive 16 times, while passive has outperformed active 15 times. Much like their respective asset totals today, I’d call that a tie. Additionally, the Hartford paper points out that active investments tend to perform better in high dispersion markets, think volatility. However, in low volatility environments, passive management tends to perform better. This would explain the massive influx into passive strategies in 2016 and 2017 when volatility was at an all-time low. 

Add the fickle nature of the typical investor (read human being…because we’re all fickle), and you’ve got a recipe for the tide to turn away from passive and back to active management. And, more than likely, if history is our guide, most will do so at the wrong time. 

Active versus Passive Management: Active is not Dead; It’s just Waiting its Turn

I love the title of the article that Daniel wrote because it’s so accurate! The rumors of the death of active management are greatly exaggerated. Yes, passive management has had a strong showing as of late and is absolutely a valid management style. However, when everything isn’t just going up in value, and skill is required to find ACTUAL value in the universe of investments, active management will once again return to favor. In fact, when you look outside the U.S. equities universe, active portfolio management is still far and away the preferred choice for investors. 95% of municipal bonds are in active management strategies. Those of you who’ve tried to buy individual bonds recently know precisely why that’s the case. International stocks and taxable bonds are also predominantly actively managed. 

Active management has its place, and always will. Passive management has its place, and always will. True wisdom in the active versus passive management debate is realizing that and knowing when to apply either, or both, or neither. 

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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.