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Active vs. Passive? It Doesn’t Matter.

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The debate between stock-pick­ing active and index-based pas­sive man­age­ment has been rag­ing for years. So far, the momen­tum is all on the side of pas­sive man­agers. Black­Rock, Van­guard, and State Street occu­py the top spots on the AUM tables, each pas­sive­ly man­ag­ing tril­lions of dol­lars. Mean­while, tra­di­tion­al stock-pick­ing active man­agers[1] have been hem­or­rhag­ing assets. Accord­ing to Morn­ingstar research[2], U.S. pas­sive mutu­al funds added $492bn in 2016, where­as active man­agers have shed $204bn. These num­bers are for open-end­ed mutu­al funds and don’t include ETFs or the shift in insti­tu­tion­al assets, where the same trends are under­way.


How the Debate Misses the Point

Each side makes valid points:

Active Man­age­ment argues…

  • Pas­sive invest­ing doesn’t allow for the effi­cient allo­ca­tion of cap­i­tal.
  • There is no atten­tion paid to val­u­a­tions, fun­da­men­tals, etc.
  • Pas­sive has no chance of out­per­form­ing the bench­mark

Passive man­age­ment argues

  • Active man­age­ment has very high fees
  • Few active man­agers out­per­form their bench­marks after fees
  • Iden­ti­fy­ing active man­agers like­ly to out­per­form is dif­fi­cult

In the end, how­ev­er, it doesn’t mat­ter.

Active or pas­sive: It doesn’t mat­ter.

The argu­ment is large­ly futile because it miss­es the point for two rea­sons.

Relative vs. Absolute Performance

First, the active vs. pas­sive argu­ment is about rel­a­tive per­for­mance, not absolute per­for­mance. There will be dif­fer­ences between the rel­a­tive per­for­mance of active and pas­sive man­agers, but absolute per­for­mance reveals the gains and loss­es expe­ri­enced. Out of these two mea­sure­ments, which one would an investor pre­fer?

By focus­ing on dif­fer­ences mea­sured in basis points, the investor risks los­ing the for­est for the trees.

Systematic Risk: the 800-pound Gorilla

Sec­ond, the active vs. pas­sive argu­ment main­ly focus­es on fees, asset allo­ca­tion, and out­per­form­ing the bench­mark. But what do they offer for mit­i­gat­ing mar­ket risk? How does an active man­age­ment approach or a pas­sive man­age­ment approach help reduce risk expo­sure?

The choice between active and pas­sive man­agers becomes irrel­e­vant because both active and pas­sive man­agers are heav­i­ly exposed to sys­tem­at­ic risk. This is the biggest risk an investor faces, yet nei­ther side real­ly address­es it.


What Does Risk Look Like?

While many invest­ment pro­fes­sion­als define risk in terms of volatil­i­ty or rel­a­tive per­for­mance, the per­spec­tive of most investors is dif­fer­ent. Most investors define risk in terms of sim­ple cap­i­tal preser­va­tion. Mar­ket risk rep­re­sents absolute risk: the risk of cat­a­stroph­ic loss or the risk of run­ning out of mon­ey.

In the graph below, we exam­ine how sys­tem­at­ic risk impacts the fol­low­ing clas­si­fi­ca­tions of man­agers[3]:

  1. Index funds with­in the large cap blend space
  2. Active man­agers clas­si­fied as Large Blend by Morn­ingstar
  3. Active man­agers clas­si­fied as Large Val­ue, Large Growth or Large Blend by Morn­ingstar
  4. Active man­agers across all nine Morn­ingstar style box­es — Large, Mid, and Small and Val­ue Blend and Growth

From peak-to-trough, how much did these man­agers lose? When the mar­kets col­lapsed between mid-2007 and ear­ly-2009, were any of the funds in this study suc­cess­ful at mit­i­gat­ing the loss­es?

Max Drawdown - Active vs. Passive Blog | Swan Global Investments

Dur­ing the Finan­cial Cri­sis of 2007 to 2009, the vast major­i­ty of pas­sive and active funds lost over half their val­ue in a very short time span. Only one fund out of 1,451 was able to lose less than 25%. This is the impact of sys­tem­at­ic, mar­ket risk: los­ing big.

When things go wrong, the rel­a­tive advan­tages or dis­ad­van­tages in the active vs. pas­sive debate are ren­dered irrel­e­vant.


The Best Way to Address Risk Directly

The bot­tom line is that tra­di­tion­al, stock-pick­ing active man­agers will not be able to stock-pick or mar­ket time their way out of sys­tem­at­ic risk dur­ing a full-blown bear mar­ket.

More­over, a pas­sive man­ag­er is sys­tem­at­ic risk by def­i­n­i­tion. If the mar­ket sells off by 30%, 40%, 50% or more, an index man­ag­er is designed to go down with the ship because a pas­sive man­ag­er is entire­ly 100% sys­tem­at­ic risk.


We believe if sys­tem­at­ic risk can­not be diver­si­fied away, it must be hedged away. An invest­ment approach that does not address risk direct­ly is an incom­plete one. By not los­ing big, investors may bet­ter sit­u­ate them­selves for long-term gains. Investors should wor­ry less about fees and out­per­form­ing and instead focus more on risk defense. Until that hap­pens, the active vs. pas­sive debate is incon­se­quen­tial.

White Paper - Active vs. Passive: Losing the Forest for the Trees | Swan Global InvestmentsOur stance and an analy­sis on the impact of sys­tem­at­ic risk on four types of strate­gies are explored in depth in our white paper “Los­ing the For­est for the Trees: How the Active vs. Pas­sive Debate Miss­es the Point.”





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About the Author:

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.



Impor­tant Notes and Dis­clo­sures:

[1] For the pur­pos­es of this dis­cus­sion, “active man­age­ment” refers to stock-pick­ing strate­gies that seek to out­per­form a giv­en bench­mark through supe­ri­or stock selec­tion, rather than any type of top-down sec­tor rota­tion or tac­ti­cal asset allo­ca­tion strat­e­gy.

[2] Morn­ingstar Asset Man­age­ment Quar­ter­ly, 1Q 2017

[3] The field of man­agers was scrubbed to include only those funds with an incep­tion date pri­or to Jan­u­ary 1st, 2007. Also, dupli­cate share class­es were removed, leav­ing only the pri­ma­ry share class.


Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®).

All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results due to offer­ing dif­fer­ences and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com184-SGI-071417

By |2018-10-02T11:13:52+00:00July 18th, 2017|Blog|Comments Off on Active vs. Passive? It Doesn’t Matter.