Active versus passive – walking a plank?

I wrote a blog back in November 2014 for Pensions Insight (sadly demised) asking: “Are you a passivist or activist?” in which I set out the arguments between passive versus active investment management. Over the weekend, the argument came up again on Twitter, and I thought I should add something else – something new and perhaps temporary but relevant to the argument: the plank effect.

I’ve drawn this picture to help to describe the plank.

The blue line shows the shape of the normal economic cycle. The economy and market – albeit on a slightly different time frame and in a more volatile manner – falls, bottoms out, grows, peaks, falls and so on, ad infinitum.

The red line shows what has happened to the economy and market recently. It has continued to grow. We are on a plank.

Now, as sure as eggs are eggs, we will fall off the end of the plank at some point. There’s just no telling when.

Why is this relevant to the active v passive debate? Because of the rule of thumb in the Pensions Insight blog (reproduced below). Passive funds tend to do better in rising markets, active funds better in falling markets. The conditions for passive funds have been benign for an unusual length of time.

So yes – over recent past passive funds in general have probably done better than active. The argument, however, will swing at the point we fall of the plank.

 

From the archive: Are you a passivist or activist?

I got caught in an interesting discussion the other day, prompted by the newly proposed “good value” requirements for Defined Contribution (DC) pension schemes.

The debate around active verses passive investment is polarised and the champions on both sides passionate. Their conviction is heartfelt, but that creates a risk. Passionate champions tend to look for evidence to support their case or discredit the opposition instead of the more scientifically sound method of looking for arguments against their case. In other words, they can become blind to reason because of their passion. For active versus passive read Man United versus Man City or Labour versus Conservative.

Trustees should be agnostic in the debate. Their strategy should be based on investment objectives rather then personal prejudice. One challenge for trustees, however, is to find dispassionate advisors.

The truth is that either strategy could be correct – given different circumstances. The problem is knowing what circumstances will prevail during the appointment being made. This being the case, passion aside, the philosophical argument for active or passive is, in truth, balanced.

 

So what can trustees do?

There are two tools that we agreed are useful. The first is a rule of thumb. A very general rule of thumb. In a rising market passive funds will do better whereas in a falling market active funds will prevail.

The logic behind this is that passive funds cost less and so, in that rising market, the active has to be 0.5% or so better a year. In a falling market, however, active funds can take defensive positions unlike the passive where you are there for the ride what ever it may be.

The passionate advocates on either side will try to discredit this rule of thumb with all sorts of stats, but ignore them. Logic proves its truth.

The second tool is to be mindful of a tilt in the balance. As I’ve outlined above, the philosophical debate is balanced but the costs aren’t.

Trustees can do very little to influence the performance of their fund managers, once they have entrusted them with cash. The return will be what the return will be, like it or lump it. What trustees can control, however, is cost. If we don’t want to pay the extra for active we can refuse to do so.

The trustees’ default setting should be to do all they can to keep costs low, although they can, of course, decide to spend more when they feel there is justification, this being the value-for-money point. The starting place, therefore, is spend low.

This tilts the balance slightly. All other things being equal, which they rarely are, trustees should be agnostic on the philosophy but evangelical on costs. In other words, passive is the proper starting point.

One final thought: this was, to a large extent, an abstract debate aired in the context of the bar being raised for trustees to prove good value in their schemes. As such it could afford to ignore some of the realities of life.

 

One such reality is that in a defined benefit world, it is the employer who bears the costs of our decisions. This means that they should have a say, assuming their covenant is up to it, on investment approach. We may decide on balance to go passive, but if they want us to go active, for whatever reason, and they are willing to pay for it, we should go active.

A second such reality is that in a DC world, it is the member who bears the costs of our decisions, and their risk profile and appetite for risk are very different from those of a DB employer. This makes it a far more complex and multifaceted decision for DC trustees.  

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