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Okay, thanksThe debate between stock-picking active and index-based passive management has been raging for years. So far, the momentum is all on the side of passive managers. BlackRock, Vanguard, and State Street occupy the top spots on the AUM tables, each passively managing trillions of dollars.
Meanwhile, traditional stock-picking active managers[1] have been hemorrhaging assets. According to Morningstar research[2], U.S. passive mutual funds added $492bn in 2016, whereas active managers have shed $204bn. These numbers are for open-ended mutual funds and don’t include ETFs or the shift in institutional assets, where the same trends are underway.
Each side makes valid points:
Active Management argues…
Passive investing doesn’t allow for the efficient allocation of capital.
There is no attention paid to valuations, fundamentals, etc.
Passive has no chance of outperforming the benchmark
Passive management argues…
Active management has very high fees
Few active managers outperform their benchmarks after fees
Identifying active managers likely to outperform is difficult
In the end, however, it doesn’t matter.
Active or passive: It doesn’t matter.
The argument is largely futile because it misses the point for two reasons.
First, the active vs. passive argument is about relative performance, not absolute performance. There will be differences between the relative performance of active and passive managers, but absolute performance reveals the gains and losses experienced. Out of these two measurements, which one would an investor prefer?
By focusing on differences measured in basis points, the investor risks losing the forest for the trees.
Second, the active vs. passive argument mainly focuses on fees, asset allocation, and outperforming the benchmark. But what do they offer for mitigating market risk? How does an active management approach or a passive management approach help reduce risk exposure?
The choice between active and passive managers becomes irrelevant because both active and passive managers are heavily exposed to systematic risk. This is the biggest risk an investor faces, yet neither side really addresses it.
While many investment professionals define risk in terms of volatility or relative performance, the perspective of most investors is different. Most investors define risk in terms of simple capital preservation. Market risk represents absolute risk: the risk of catastrophic loss or the risk of running out of money.
In the graph below, we examine how systematic risk impacts the following classifications of managers[3]:
Index funds within the large cap blend space
Active managers classified as Large Blend by Morningstar
Active managers classified as Large Value, Large Growth or Large Blend by Morningstar
Active managers across all nine Morningstar style boxes — Large, Mid, and Small and Value Blend and Growth
From peak-to-trough, how much did these managers lose? When the markets collapsed between mid-2007 and early-2009, were any of the funds in this study successful at mitigating the losses?
During the Financial Crisis of 2007 to 2009, the vast majority of passive and active funds lost over half their value in a very short time span. Only one fund out of 1,451 was able to lose less than 25%. This is the impact of systematic, market risk: losing big.
When things go wrong, the relative advantages or disadvantages in the active vs. passive debate are rendered irrelevant.
While many investment professionals define risk in terms of volatility or relative performance, the perspective of most investors is different. Most investors define risk in terms of simple capital preservation. Market risk represents absolute risk: the risk of catastrophic loss or the risk of running out of money.
In the graph below, we examine how systematic risk impacts the following classifications of managers[3]:
Index funds within the large cap blend space
Active managers classified as Large Blend by Morningstar
Active managers classified as Large Value, Large Growth or Large Blend by Morningstar
Active managers across all nine Morningstar style boxes — Large, Mid, and Small and Value Blend and Growth
From peak-to-trough, how much did these managers lose? When the markets collapsed between mid-2007 and early-2009, were any of the funds in this study successful at mitigating the losses?
During the Financial Crisis of 2007 to 2009, the vast majority of passive and active funds lost over half their value in a very short time span. Only one fund out of 1,451 was able to lose less than 25%. This is the impact of systematic, market risk: losing big.
When things go wrong, the relative advantages or disadvantages in the active vs. passive debate are rendered irrelevant.
Even though Gamma does not directly measure changes in option values for changes in underlying prices, it is still an important risk measurement. It signifies the potential changes in option premium as measured by Delta. Many option premium strategies are short term in nature, and as a result, these strategies take on a tremendous amount of Gamma risk. Premium selling strategies that appear Delta-neutral may have hidden risks such as Deltas moving around as options approach expiration or the potential for certain types of spreads to produce an inordinate number of Deltas under certain market conditions.
NEXT ARTICLEOur stance and an analysis on the impact of systematic risk on four types of strategies are explored in depth in our white paper “Losing the Forest for the Trees: How the Active vs. Passive Debate Misses the Point.”
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Marc Odo, CFA®,CAIA®, CIPM®, CFP®, Director of Investment Solutions, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. Formerly Marc was the Director of Research for 11 years at Zephyr Associates.
[1] FT Alphaville, “It’s Really Very Quiet Out There,” David Keohane, May 3, 2017
Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (“DRS”). SEC registration does not denote any special training or qualification conferred by the SEC. Swan offers and manages the DRS for investors including individuals, institutions and other investment advisor firms. Any historical numbers, awards and recognitions presented are based on the performance of a (GIPS®) composite, Swan’s DRS Select Composite, which includes non-qualified discretionary accounts invested in since inception, July 1997, and are net of fees and expenses. Swan claims compliance with the Global Investment Performance Standards (GIPS®).
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