Active vs Passive Investing: A Hotly Contested Debate

There is no single, preset approach to designing an investment menu for defined contribution retirement plans. Accordingly, there are a plethora of highly contested ideas and theories around menu construction and how to maximize the value to participants through the plan’s investment offerings. One of the most prominent, and often most polarizing, menu design considerations is the superiority of active or passive management for plan investments. With a fundamental understanding of how active vs passive investing approaches work, as well as the pros and cons of each, plan sponsors can make more informed decisions in their menu construction.

Why Passive?

As the name suggests, passive investment management is a more “hands-off” approach to putting money to work in the markets. So how does passive management, or indexing, work? In essence, the passive investment manager identifies a segment of the market that he or she would like exposure to (e.g. U.S. large-cap equities), then pinpoints a benchmark index of securities that represents the experience of that market segment (e.g. the S&P 500 Index). The investment manager then creates his or her own portfolio of securities to replicate the exposures and performance of that index as closely as possible.

There are many benefits of index investing. The simplified, low turnover investment strategy provides investors with broad, diversified, and transparent exposure to the markets, all at a very low cost. Particularly in more efficient segments of the markets (e.g. U.S. large cap), there is also significant data to support a passive approach, with evidence showing that active managers are predisposed to underperform over time.

Despite these benefits, passive investing can in some circumstances have several noteworthy drawbacks. Less efficient asset classes and market segments (e.g. small-cap and emerging markets equities) provide a more ample opportunity for active managers to add value, and the value proposition of passive strategies in these categories is therefore diminished. Certain segments of the market are also limited in index coverage, meaning a passive investment strategy that wholly covers a particular market segment may not exist, or may provide incomplete representation. Lastly, as passive investing seeks to provide investors with a nearly identical experience to that of a selected benchmark, there is no flexibility to deviate. This can be problematic in periods of market stress, where investors in index strategies are locked into the index’s holdings, regardless of how those securities are performing.

It is also worth noting that, net of their associated expenses and trading costs, index strategies will always technically underperform their benchmarks – a criticism much more commonly made of actively managed funds – though underperformance is limited.  Some managers may employ portfolio strategies, such as securities lending, to compensate for those costs.

Why Active?

An active approach to investing involves the investment manager taking an active role in the selection of securities held in a portfolio over time. The most commonly cited objective of an active investment strategy is to generate returns in excess of a market segment by identifying and pursuing under-appreciated investment opportunities. Active managers also typically manage the risk of their portfolios with some discretion to further add value for investors.

The potential benefits of an active investment approach are clear. When executed well, investment managers can generate outperformance that can be very meaningful when compounded over time. At the same time, the active management of portfolio risk exposures can add significant value, particularly in challenging markets. With a more hands-on approach to portfolio construction and maintenance, active managers can be more intentional with the objectives of their strategies, providing investors with investment choices that better suit their specific needs.

The largest potential drawback of actively managed strategies, and the primary reason why the case for passive funds is so compelling presently, is the risk of underperformance. In the same manner that an active manager’s decisions can add alpha over an index, unfavorable active positioning can result in, sometimes sizable, underperformance. Echoing what was noted previously, this has historically been a well-acknowledged pitfall for active management. In more efficient asset classes, active managers have struggled to consistently add value.

Given the additional resources required to successfully run an active strategy (research, trading, other oversight costs), actively managed investments are also typically far more expensive for investors to access than their passively managed counterparts. A higher cost presents a higher hurdle for active managers to overcome in delivering net returns ahead of their benchmarks.

Why Not Both?

If at this point you are still having trouble determining which approach makes the most sense – active vs passive investing – there is not some hidden piece of information you missed that would have given you an answer! After weighing the pros/cons of both approaches, we argue that there is no clear winner. Instead, we feel that there is value in both approaches, and the two can actually be quite complementary when thoughtfully leveraged in a plan’s menu design. For example, the additional cost of an active strategy may be well warranted in fixed income asset classes where there is not good index representation, or alternatively in an inefficient market segment like international equities where active managers are statistically more likely to succeed. These active strategies can be paired with low cost index funds in other fund categories where active managers have been proven to have less of an edge, and/or where broad, low cost exposure is desired.

Ultimately, plan sponsors should seek out investments that cater best to strong participant outcomes, and should have a well thought-out and documented approach for identifying such investments. With a better understanding of the defining characteristics of active vs passive investing, sponsors can provide the best of both worlds to their participants with confidence as plan fiduciaries.

Why Work with PlanPILOT?

If designing the investment menu for your retirement plan is outside of your fiduciary knowledge, seek help from a retirement plan adviser. Plan sponsors can choose to work with an ERISA 3(21) or 3(38) fiduciary to assist with the investment selection. PlanPILOT is an independent registered investment advisor (RIA), not tied to any funds or investment banks. We help clients control their risks in operating retirement plans and help them deliver the benefits intended. We also review fund lineups and score investments, highlighting any recommended changes. We encourage you to contact us at (312) 973-4911 or info@planpilot.com so we can help your retirement plan administration team and plan participants achieve better outcomes.

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