Active and Passive:
Complementary, Not Competing, Strategies
Victor Zhang, Co-Chief Investment Officer
- The Active/Passive Debate. The tension between active and passive approaches is growing as investors shift assets from active strategies to passive exchange-traded funds (ETFs) and index-replicating products. An extended period of active manager underperformance, as well as concerns about management fees and potential regulatory changes, are driving this shift. There also is continued debate around the efficiency of financial markets—proponents of efficiency argue for passive approaches, while behaviorists make a compelling case for active strategies.
- No Longer Either/Or. We view active and passive approaches as complementary, rather than competing, strategies. Portfolio construction and achieving financial objectives are complicated problems, and it strikes us as shortsighted to exclude half of the investment tools at your disposal out of hand.
- Look Beyond Relative Performance. Defining active management solely as an exercise in beating benchmarks casts the problem in the wrong way. Rather, we believe active management should be understood as a comprehensive exercise to design solutions to clients’ financial problems. Certainly, building multi-asset portfolios requires active decisions about portfolio construction and asset allocation. Further, it requires an active decision to determine where to go passive and where to go active.
- Passive Isn’t a Panacea. While indexing has obvious appeal as a cheap, efficient way to gain access to many markets and generate benchmark-like performance, it has some limitations. Not all markets are effectively or cheaply replicated, and passive approaches can experience high tracking error when volatility spikes. In addition, capitalization-weighted indices carry underappreciated geographic, sector, industry, and security concentration risks, particularly during market bubbles. In addition, we find that active and passive approaches trade market leadership over time and the analysis of relative performance is highly end-point sensitive.
- Active Management of Market Risk. Active strategies tend to work best relative to passive during periods of uncertainty, high volatility, and high dispersion of returns. This was particularly evident during the internet stock bubble and 2007-09 financial crisis, two events often cited by behaviorists in their case against market efficiency. Precisely because risk in passive strategies is always equal to full market risk, we prefer to construct our own asset allocation portfolios using active strategies and a risk-aware approach.
- Active Managers Have a Role. Investors are correct to evaluate the role of active strategies in their portfolios and demand value for the fees they pay. Nevertheless, we believe superior active managers who consistently deploy their unique insights in service of solving a client’s most pressing financial needs can and will continue to thrive.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.