Advisors historically invested exclusively in either active strategies or passive strategies, rarely using them together. We are proponents of blending the two strategies, having the firm belief that combining active and passive strategies provides a superior risk-return profile than exclusively using one or the other.
We're not the only ones who are seeing the virtues of blending active and passive investments. Many advisors are recognizing the benefits of integrating high value-added active strategies with low-cost, tax-efficient passive strategies. However, many advisors also make the active/passive decision subjectively, often being overly influenced by buzz surrounding the latest hot performing fund or investment vehicle.
We think it worthwhile to share the framework and thought process that we use, which we think removes most behavioral biases from the investment process. Using such a framework and following such a process provides a better investing solution to your end clients, we believe, while also making the advisor more efficient.
The Active/Passive Decision Framework
Deciding whether to invest in active or passive strategies is based largely upon a review of historical data for the asset classes under consideration. The bar is set pretty high for active management to beat passive, given the "headwind" of transaction costs and taxes. Because of the natural cost and tax advantages of passive funds, in essence active funds have to prove themselves to be superior in order to prevail in our selection process.
The major factors in evaluating active managers should include:
1. Active return potential. An important question to answer is the degree to which picking winners will help the portfolio. We've observed advisors going to extreme efforts to try to identify the best manager in a given asset class. To us, that effort only makes sense if there will be a reasonable payoff for picking a top-performing investment.
Taking on additional cost and tax impact may not make sense if the added return is small relative to the return expected from an average-performing fund or an index fund. We evaluated the active return potential by reviewing the spread between success and failure among fund managers as defined by the performance spread between the top quartile (25th percentile) and the bottom quartile (75th percentile), as well as performance comparisons between active and index returns.
This criterion helps identify whether the cost and risk of active management is worth it. The broader the spread between the top performers and the index or bottom performers, the higher the potential payoff from active management (see Figure 1).
2. Repeatability of outperformance. It's an unfortunate fact of life in the investment industry that many of today's top-performing funds are tomorrow's bottom performers. The more random that performance success appears to be, we think the lower the odds of being able to pick a manager who thrives over time. We evaluate the persistence of success by examining the percentage of top quartile managers in one market cycle who stay in the top quartile for the subsequent market cycle (see Figure 2).
3. Batting average relative to the index. We also evaluated the ease with which managers can beat the index by examining the percentage of funds that do so. The batting average follows our thinking about repeatability.
Findings indicate that few managers beat the index and that an even smaller number of the outperformers who sustain their outperformance favor index approaches for that asset class (see Figure 3).
Looking Ahead
Although we are largely influenced by empirical data in our investment process, we think it prudent to augment the data with forward-looking judgments about each asset class. The primary factors we assess are:
