Active investment and passive investment have long been regarded as polar opposites. With passively managed funds continuing to increase market share versus their actively managed counterparts, the traditionally heated debate between disciples of the two approaches is evolving.
Historically, passive management is an investment strategy that attempts to replicate the returns of an index or benchmark by owning the same assets, in the same proportions, as the underlying index.
Active management, on the other hand, attempts to outperform the market through the art of stock picking and market timing.
For example, a passively managed large-cap fund would own all 30 stocks listed in the Straits Times Index (STI), whereas the active large-cap manager might try to pick the best 10 to 20 STI stocks or any stocks outside the index to his discretion, for inclusion in a portfolio.
LOOKING AT THE DATA
By any measure, passive investment has momentum. According to the S&P Indices versus Active Funds Scorecard Year-end 2014 Report, 89.87 per cent of large-cap core, 85.92 per cent of large-cap growth and 82.42 per cent of large-cap value fund managers underperformed their benchmarks over the past five years. Small- and mid-cap funds fared poorly as well, with between 78.32 and 92.63 per cent of funds underperforming their benchmarks across the small and mid, growth and value style boxes during the past five years.
And, not surprisingly, money has followed performance.
According to the Investment Company Institute, from 2007 to 2013, indexed United States equity mutual funds and exchange traded funds received US$795 billion (S$1.14 trillion) of net inflows while actively managed US equity mutual funds experienced net outflows of US$575 billion. And Morningstar reported that actively managed US equity funds experienced US$98.4 billion of outflows while passive US equity funds received US$166.6 billion last year.
The penchant for passive index investing has even spilt over to the fixed-income side, illustrated by the fact that last year, the total assets of the world's biggest bond fund were overtaken by an index fund. All told, passive assets now account for 28 per cent of total mutual fund industry assets, up from approximately 10 per cent in 2001.
A NEW MIDDLE GROUND
Despite passive investment gaining momentum, active management is still here to stay. There are a number of reasons why active management may be the right fit for particular investors. For instance, many investors focus on individual funds rather than the holistic portfolio - a term we call "line-item" risk - making lower-risk actively managed funds easier to stick with than the more volatile indexes.
Also, there are many asset classes that cannot be easily indexed, such as certain fixed-income markets or illiquid asset classes such as private equity and direct real estate.
Finally, there are some asset classes that are less efficient, such as some emerging market countries or specific fixed income segments, which active managers can generate alpha on a more consistent and significant basis.
However, with the increase in exchange-traded fund (ETF) issuance, selecting an index product is rapidly becoming as challenging as selecting an active manager. For example, the 54 ETFs in the Morningstar Large Cap Blend ETF category provided returns ranging from 2.32 per cent to 16.85 per cent last year. Index construction, fees and other factors have made selecting an index product much more complicated than simply choosing an asset class.
BRINGING IT ALL TOGETHER
As a result, the real question is not whether to choose active or passive strategies, but how to combine the best of both approaches in a holistic way to build a portfolio that meets the specific risk and return profile of different investors.
For example, Singapore retail investors can combine active and passive strategies by using passive ETFs for core and broad exposure to the market, such as the SPDR Straits Times Index ETF, while actively selecting stocks that they view favourably to gain any potential out-performance.
The proliferation of the ETF industry has been a major contributor to the growth in passive assets, which provides investors with a wider range of investment choices in addition to active products.
ETFs are considered to be some of the most attractive passively managed vehicles. They are baskets of securities that track an underlying index to offer investors exposure to an entire market or market segment. They benefit investors in a number of ways, including trading flexibility, transparency and easy, lower cost market access.
At the end of the day, how investors combine active and passive strategies depends on various conditions, from their market outlook to investing philosophy.
The lower cost of passive investment approaches may make them more practical for some cost-sensitive retail investors while active investment approaches could be suitable for a long-term, buy-and-hold position in an asset class where active management has historically shown its ability to deliver alpha.
• The writer is ETF business development manager, Asia ex-Japan at State Street Global Advisors.