The Great Investment Debate: Active or Passive Strategies?

In this first of a two-part series, Brad Swinsburg, Director of Investments at Smith & Howard Wealth Management discusses the differences and pros and cons of active versus passive investment strategies.

The asset and wealth management industry has a tendency to turn every investment debate into a binary decision - buy or sell, black or white, bull or bear.  In an industry that typically rewards those with strong opinions and loud voices, most investors whether professional or amateur, feel forced to make a choice and then proclaim their eternal allegiance. 

It is for that reason that when I’m asked if I believe in active or passive strategies I rather enjoy answering with a simple….”Yes”.  That response is typically met with a brief look of confusion followed by a look that says “I see what you did there” (and hopefully at least a little laughter!).  While we at Smith & Howard Wealth Management have a preference for passively managed strategies, we do not believe it is necessary or even prudent to simply write-off all active strategies.  At particular points in time or in specific markets or strategies, an actively managed approach may be appropriate.

Before we jump into the debate and our view, it probably makes sense to discuss briefly what is meant by the terms active and passive within an investment vehicle framework.  On a simple level, investors have two basic methods of implementation when constructing a portfolio: active and passive.  

  • An active strategy involves an individual or team of individuals making specific stock/security selections with a goal of outperforming a stated investment benchmark or index.  
  • A passive strategy attempts to simply mimic the benchmark or index return.  

While the active approach is what most investors are likely familiar with, the passive approach has grown tremendously in both use and popularity over the last two decades due to its low fee structure and the general failure of active strategies to exceed their benchmarks on any consistent basis.

Most individuals that fall squarely into the passive camp point to performance as the primary driver.  Performance over the last several years has supported that conclusion, and frankly it hasn’t even been close.  As a result, it would certainly be easy and defensible to jump onboard the passive bandwagon with both feet, but as a student of history and behavioral finance with nearly 20 years in the business, I’ve learned the value of a healthy dose of skepticism.  Yes, performance for passive strategies has exceeded that of active for several years running, but in a cyclical business one must constantly guard against recency bias - the inclination of individuals to use our most recent experience as the baseline for what will happen in the future.  Everyone may roll their eyes when they hear the disclaimer that “past performance is not necessarily indicative of future results”, but that doesn’t make it any less true.  

A Historical Look at Active and Passive Strategies

Looking at a longer history or different end points illustrates performance cyclicality between active and passive strategies.  The chart below was produced by Callan Associates and shows their active Large Cap domestic manager universe versus the S&P 500 over the prior 12 months going back to 1991.  This rolling performance line depicts the percentage of managers beating the index, so when the number is higher (or below the 50% on the graph) the active strategies performed better than the index. When the line is above the 50% mark on the graph, active managers are underperforming the index.

Callan Chart - One-Year Rolling Periods

 

If we assume that this performance cyclicality will continue (cyclicality is one of the few things one can count on in investing!) then the decision between active and passive needs to consider factors beyond simply performance.  One of those factors in favor of passive strategies is unquestionably their low cost nature, but it is also fairly obvious and well documented and happens to be one of the primary drivers of the outperformance.  

Next, we  dive a little further into a few of the other characteristics that tilt the argument further in favor of passive and are perhaps a bit less obvious or understood.  We’ll also articulate situations or circumstances in which we believe an actively managed strategy may be the best vehicle to utilize for a particular investment view or strategy. To get started on Part Two, click here.

I would be happy to discuss our philosophy in more detail with you, or to explore with you how SHWM can work with you to help you achieve your financial goals. Please call me at 404-874-6244 or email me here.

All references in this publication referring to our average allocation or “typical portfolios” reflect those of the fully discretionary accounts of clients with moderate risk profiles. Actual client portfolios are tailored to individual client circumstances and asset allocations may vary.  Any reference to returns reflect the performance of asset classes, are for illustration purposes only, and do not reflect the returns of any specific investment of Smith & Howard Wealth Management. No representation is made that any investment decisions discussed herein have been profitable in the past or will be in the future. Past performance is no guarantee of future results. A list of all recommended investments is available upon request.