A recent Vanguard research paper opens with a challenging question that investors are increasingly asking themselves: How should I allocate my investment capital across index and active investments?
The paper, Making the implicit explicit: A framework for the active-passive decision, is intended to provide a framework for making a clear and informed decision about a possible passive-active split of investments.
In the absence of a structured decision-making process, investors are left making “ arbitrary decisions based on implicit assumptions” , Vanguard analysts write.
As the paper notes, the active-passible debate tends to focus on an all-or-nothing approach.
“ Proponents of passive investing point to research demonstrating that the median active manager underperforms after costs and that outperformers are difficult to recognise in advance,” the paper observes.
“ Meanwhile, proponents of active investing argue that despite the underperformance of the median active fund, many active managers do still add value, and the impact of possible outperformance can be significant,” the paper adds.
It rejects any suggestion that investors face making a basic choice between either index or active investments, saying that both have potential benefits for a portfolio:
- “Passive funds offer low-cost benchmark tracking, leading to a tight range of relative returns.”
- “Active funds offer the potential for outperformance in exchange for a wider range of relative returns – in other words, greater uncertainty – and typically higher costs.”
The researchers describe indexing as a valuable starting point for all investors with many deciding to index their entire portfolios. “ But our analysis shows that those who are comfortable with the characteristics of active investments, an allocation to active can also be a variable solution.”
From using index investing as a starting point, the paper proposes a clear process to help investors make decisions on whether to gain exposure to active management and on the size of any exposure.
Its decision-making process covers four variables relating to active management success:
- Gross alpha expectation: This is an investor’s expectation for an active manager to outperform its benchmark. It’s a critical judgment of a manager’s talent. “ Each investor will have his or her own methods of attempting to identify talented managers and developing gross alpha expectations for them.” Investors would, of course, often take advice.
- Cost: This is described in the paper as the “enemy”of outperformance. “Evidence shows that the odds of outperformance increase as the as investors are able to reduce the cost of active strategies. Indeed, low cost is the most effective quantitative factor that investors can use to improve their chances of success.”
- Active risk: Any active fund, “by its nature” , deviates from a benchmark in the attempt to improve returns. Adding active managers adds manager risk. “No active manager will outperform the market every day, every week, every month, or even every year.” And even the most successful managers over the long term will typically experience long periods of underperformance. This inconsistency of returns can be quantified as the volatility of a fund relative to its benchmark.
- Active risk tolerance: This is an evaluation of the degree that an investor is willing to take on additional risk in the pursuit of outperformance. It is at the heart of the risk-return trade-off for investing in active funds.
One of the critical conclusions of this research paper is that there is no one-size-fits-all approach to making a decision on the index-active investment split.
So much depends on investors’ personal circumstances including their return expectations, their tolerance to risk, their ability (perhaps with professional assistance) to identify talented managers and their patience to withstand an active manager’s inevitable periods of underperformance.