By Daniel Dos Passos

Much has been written over the years about active versus passive investment management and the debate over which is better is never-ending. This article, however, isn’t one of those, as we feel that managing a portfolio, whether actively, passively, or somewhere in between, still requires skill and knowledge of financial markets. As George Soros once said, “There is always a divergence between our perception and what actually exists”.

First off, I take my hat off to the active managers in the market. Being an active manager is difficult, especially in volatile markets and a highly competitive landscape. Whether focusing on a top-down macro asset allocation strategy in a multi-asset portfolio, a bottom-up approach based on fundamentals in an equity portfolio, or seeking risk-adjusted returns across a yield curve, things are not always simple. The various skill sets of active managers can be varied and highly specialised.

The decision to invest in a passive strategy that looks to track an index can be a very active decision. Especially in the context of trying to generate active or “alpha” returns beyond the benchmark. Whether this is to invest in a traditional market capitalisation strategy, focusing on a specific sector, or trying to seek exposure to various factors in the market such as growth, value, momentum, low volatility, or duration.

Passive investing requires skill too

People often take for granted the subtle skills required of passive managers. Much attention is given to the skill of active managers, their investment decisions and how they navigate the markets. However, a common misconception is that being a passive manager and tracking an index is simple.

While active managers spend hours analysing the balance sheets of companies and their earnings, screening economic data and news events, or paying attention to the bond duration and convexity, passive managers likewise spend hours doing research. Passive managers spend time screening viable liquid indices to track, understanding the ground rules of the indices they track, how various indices are calculated with regards to specific factors, decomposing the various variables of an index and screening for announcements relating to index changes.

Passive managers have many things to consider when tracking an index, sometimes from a different perspective than that of active managers. Liquidity events, especially around index rebalances are a key consideration for passive managers. Knowing how to navigate these can be complicated. Likewise, the impact of corporate actions requires careful consideration, not only in the context of a portfolio and performance but also concerning the treatment of such events in relation to an index.

Another interesting consideration for passive managers is cash balances and cash management within a portfolio. Typically, cash can often be seen as a short-term risk mitigation tool within a portfolio and is often used to actively de-risk a portfolio from risky assets. While active managers might decide to hold relatively high cash balances to reduce the overall risk in their portfolios, passive managers holding relatively high cash balances can pose a different dilemma, commonly referred to as a “cash drag”.

Understanding the risks of cash drag

Cash drag is the theoretical opportunity cost of not investing in risky assets. When the mandate of a fund is to deliver the returns on an underlying index that it tracks, not being fully invested in the underlying assets of an index could result in a negative cash drag on the performance of a portfolio. Admittedly, an over-exposure to cash could also generate a positive cash drag relative to an index in a bear market. However, passive managers are evaluated based on their ability to track an index and excessive cash drag, whether positive or negative can demonstrate the underlying skill of the passive manager. This is generally observed in the performance difference of a portfolio relative to that of the index that the manager aims to track, often referred to as the tracking difference.

The art of tracking indexes

Passive managers also need to consider costs, efficiencies, Assets Under Management (AUM) and the universe of assets that make up an index. As such, passive managers may consider various options when looking to track an index. This could be a full replication strategy or an optimised strategy.

In its purest form, passive managers would typically look to fully replicate an index, which essentially looks to hold all the underlying assets in an index in the respective index weights. However, in some indices, the universe of underlying assets can be significant or access to certain markers can be expensive. At this point the costs of investing in all the underlying assets relative to the AUM in a portfolio could be significant and increase the overall tracking difference of a portfolio. This could result in passive managers looking to implement an optimised tracking strategy which looks to reduce the tracking error of a portfolio, as opposed to the tracking difference.

Tracking error is a statistical measure which looks to reduce the standard deviation in performance of a portfolio relative to an index that it looks to track. As such, a tracking error could result in positive or negative returns relative to an index. Over time a lower tracking error would result in long-term returns being close to that of the index which it aims to track.

In conclusion: perceptiveness matters

In summary, asset management and skill can be perceived in different ways, with passive managers having their own skill sets. All managers need to be close to changes in financial markets. Economic events, industry trends, and corporate restructures are important to both active and passive managers, just sometimes from a different perspective.

I’ll close on a quote from William Feather:“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.”