Isn’t passive, a bit active?

20170416 Fish

Over the past few years, passive strategies have increased significantly in popularity compared to active strategies. This is perhaps not surprising given that stocks have been pretty buoyant and as a result passive strategies which track a broad based equity indices have performed relatively well. The argument is that passive strategies have very low fees associated with them, when you compare then to active strategies, and still seem to outperform (at least recently!). However, I think this is perhaps ignores the fact that “active” strategies are not all the same. Simply lumping them together is a bit like saying that all passive strategies are the same (and they certainly are not, investing in an S&P500 tracker will produce very different returns to a Barclays Global Agg bond tracker). Also the question of simply using “returns” as a motivator for any investment decision, kind of ignores all the other factors we use when judging an investment. Take for example a CTA style strategy, one of the main benefits is that it helps to diversify returns of long only passive strategies. Yes, when stocks are going gang busters continually making all time highs, you should have invested in a passive stock tracker (it’s easier to time after the event obviously!), but when stocks trade poorly, historically, it’s been beneficial to having exposure to a CTA/trend following strategy. But, the only way such an approach works if an investment in a CTA style strategy is held for a long period of time.


Also there is the question of what we mean by a passive strategy. If our passive strategy involves tracking the S&P500 as an example, our strategy follows an index, which is by definition an active strategy. It will periodically rebalance, when S&P move companies in and out of the index, and the weighting is by capitalisation. The same is true of a bond index, such as the Barclays or JP Morgan’s global bond indices. Whilst the management feels for such trackers might be very low, we should note, that there will some element of transaction costs associated with the rebalancing. Admittedly, these costs are likely to be smaller on both accounts than what we would usually think of as an “active” strategy, but they will still be present. We could also argue that some “active” strategies such as the so called alternative beta style strategies have become more common, to some extent we should consider these as market style benchmarks. Hence, if we want to follow market benchmarks should extent to these more active strategies, and use a factor based approached to our allocation. We can also break down our active strategies into alternative beta style strategies and more alpha based strategies, and try to understand how these might fit into our portfolio. Furthermore, the way many alternative beta style strategies are implemented can differ significantly. Alpha style strategies might have higher risk adjusted returns, but they might have barriers in terms of capacity and also might not be quite as persistent (eg. higher frequency style strategies). In asset classes, such as FX, where there is no “obvious” market beta such as S&P500, the way we construct markets betas, is literally to create portfolios of alternative style active beta strategies, such as carry and trend.


So yes, passive strategies might have outperformed recently, but they might be more active than you think to begin with. Furthermore, the benefits of active strategies cannot always simply be measured in the absolute returns they might generate, but the diversification benefits they can bring to your portfolio, helping to reduce drawdowns and improve risk adjusted returns. That of course means taking time to find the right active strategy to complement your portfolio, to help improve return characteristics, rather than treating “active” as one massive bucket of strategies, somehow lumping together all alternative beta and alpha style strategies into a portfolio, which we can select as one massive group. Furthermore, fees have begun to come down on many active strategies, helping reduce one of the stumbling blocks given by detractors. As history also shows us, stocks do not go up forever, even if they have gone up for the majority of the time. I suspect passive strategies would likely become somewhat less popular in a sell off style scenario (ok, this is somewhat stating the obvious!). Passive strategies have their place (which are perhaps more active than we might think too!), but so do active strategies.


If you’re interested in the question of alpha versus beta and the targets investors use for investments, there are several chapters in my book on the subject, Trading Thalesians – What the ancient world can teach us about trading today (Palgrave Macmillan).