Financial planning

Active / Passive

The aim of this paper is to reframe the active / passive debate and focus on what matters – how to deliver risk-adjusted returns and how best to support clients as they seek to achieve their investment goals and objectives.

Passive investment vehicles track markets by holding portfolios that mirror representative indices. Such vehicles are attractive as they provide close to market returns at low cost and in efficient markets the scope for outperformance from active management is limited. Active investment approaches aim to identify opportunities to outperform a market or index and are typically more costly than passive approaches. The appeal of active investing is thought to be linked to the belief that investors will attain a higher risk-adjusted return.

Passive investment makes best sense where markets are efficient and where there is little scope for active management to generate the additional return required to justify the higher fee. However, market efficiency depends on the work of active managers. Passive managers are price-takers; whereas active managers are price makers.

As the factors affecting a security’s valuation change over time, so its price should change. As the total share of assets under management invested passively grows, market efficiency may diminish (and volatility may increase) providing active managers with additional opportunities to generate excess returns. In the meantime, passive management provides low-cost access to efficient markets and maintains pressure on active management fees.

The growth of passively managed assets has enhanced the scrutiny of active asset managers, especially in the current low return environment. The debate is typically framed as a binary choice between either an active or a passive approach rather
than focusing on the costs and benefits related to each method.