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What is the better approach to investing – Active or Passive Investment Management?

It’s a question debated over the years. Passive advocates believe you should gain inexpensive exposure to beta (the market) through index funds and those like it, while active advocates believe there are managers who can add value, either in the form of higher returns or reduced risk relative to an index.

The answer to which is better is not as clear as supporters on either side would like you to think.  I actually believe it is a combination of the two.

I believe that truly active managers can bring alpha (value) to the table. Notice I said truly active managers; that’s the critical qualifier.  I also believe that the real issue is not active vs passive, but instead, is determining where to be active and where to be passive.

Is there evidence to support that active management can indeed add value, and is there correlation between the truly active managers and the value added?  Keep in mind, active is defined by difference vs a benchmark, not trading activity.

A 2006 Yale study titled “How Active is Your Fund Manager” addresses these questions. This study examined a number of mutual funds over time with a focus on the degree individual fund managers differed from their respective benchmarks, in other words, how actively they managed the fund.  They called this difference – Active Share.  The larger the Active Share, the greater the difference relative to their benchmark. What the study found was that truly active managers (those with higher Active Share) typically had better long-term performance relative to those that were less varied.  And by definition, these managers were more likely to be significantly different from their benchmark. Those differences represented value.

So, if there is evidence that Active Management can add value as measured in outcomes, what might an active manager do to add that value?

A 2000 paper by Russell Fuller identifies 3 ways a manager can add alpha or value:

  1. Superior Information – Having knowledge that others don’t
  2. Process Information Better – Better able to use information
  3. Behavioral Biases – Better able to recognize opportunities and mistakes

When you are considering a manager (or even evaluating the one you already have) be certain of whatever value they bring, that it is supported with evidence, and that you understand it. That will give you the confidence you must have that enables you to stick with that manager when their edge is out of favor…which will happen.  Just ask any value manager.

Also, use good sense when considering your manager’s purported strength.  There are thousands of analysts and advisors out there…most pretty bright and all with varying degree of training and experience.  If someone claims their “value” is being smarter than others, or a better user of information, I might wonder how that is supported.  I would want a clear explanation of just what it is they do that is unique to their process.

We don’t claim #1.  We’re a bit of #2 as we use information available to all but understand it and apply it differently than most. Our real “value” if you will, is our focus on the behavioral tendencies and limitations of investors.  Our application of this “value” is a process that is rules-based, quantitatively driven, risk managed, and allows for the ability to adapt.

So are we active or passive managers?

We are active managers where we can support decisions with compelling evidence. We are passive where we cannot.  It’s a collaborative effort between the two schools of thought.