Numerous factors have been driving the development of passively managed vehicles and their increasing weight in institutional investors’ portfolios. In particular, a recent PwC study showed that the weight of passive investments in global pension funds’ portfolios grew from 19% in 2017 to 25% in 20201. Key benefits are that their performance (relative to their reference index) is highly predictable, their costs are typically lower than those of actively managed vehicles, and the range of available instruments has increased considerably in terms of geography, sector, investment theme and type of index. Furthermore, the growth of smart beta indices has offset significantly the inefficiency of conventional capitalisation-weighted indices and expanded the opportunities to customise the implementation of a given strategy.
Meanwhile, the capacity of active managers to consistently outperform their benchmark has been widely debated by academics and professionals. Nevertheless, passive management is not a panacea. Investors should be aware that tracking-error tends to increase in certain market circumstances, particularly in very volatile environments, which can be more of an issue for passive vehicles whose performance is expected to be more predictable. Moreover, standard indices are often tainted with construction biases, such as a high degree of risk concentration in a limited number of securities. It should also be added that if all investors were to adopt standard passive investing, trading volume would be essentially explained by market capitalisation, leading to a crowding of trades and hence jeopardising the faith in market efficiency. Active management is still needed alongside passive management to allow the market to function efficiently.
The choice between active and passive management is actually an important one when it comes to implementing a given asset allocation decision and investors regularly ask for our advice on this matter. Our Multi-Asset investment experience leads us to recommend combining active and passive vehicles: active and passive management respond to different investor needs and market environments, as the latter influence the relative performance of different investment approaches. As a result, Multi-Asset portfolios are able to mix dynamically active and passive vehicles, depending on market trends and investors objectives, thus allowing our clients to benefit from the advantages of both types of approach. It should be added that choosing a passive strategy is in itself an active decision, particularly when considering the choice of the benchmark of the selected strategy.
In the current post-Covid-19 context, investors will probably modify their asset allocation as a result of the increased probability of higher inflation scenarios. When integrating new asset classes in this perspective, passive solutions could be appropriate as a first step, before moving into active strategies. Regarding the latter, investors should be aware that active managers that will outperform in the new expected environment will not necessarily be the same as in the past.
As well as providing a refresher of how to define the “activeness” of a portfolio and how to measure it, we will provide a short summary of academic observations about whether active management is rewarded, before describing the relative advantages of active and passive management. We will then share our insights on the indicators institutional investors should look at before deciding which of these styles to favour in their portfolios and outline some investment cases based on our advisory and management experience to illustrate potential approaches.
The authors would like to thank Marie Brière, Alessandro d’Erme, Thierry Roncalli, and Paul Weber for their contributions and references to their work, as well as Claudia Bertino, Laura Fiorot, Karin Franceries, Miriam Oucouc, and Laurent Trottier and for their careful reading and valuable comments.
1Pwc and ALFI: “Beyond their Borders”: Evolution of foreign investment by pension funds, 2020 Edition.