Active vs Passive Approach – A False Choice

Active vs Passive Approach – A False Choice by Mazin Jadallah, AlphaClone

If you’ve spent any time learning about AlphaClone’s investment approach, you know our goal is to combine the best of active and passive investment approaches into one.  Our strategies are passive because they are 100% rules based and comprise an index that can be tracked by a publicly traded security such as an ETF.  We can also be thought of as active because we seek to identify and follow the high conviction investment holdings of the world’s most established active managers.  Our strategies can also vary their market exposure over time which has traditionally been an attribute of active investment strategies.

The best of passive and active.  It’s a new approach and one that runs counter to the media-fueled brawl between proponents of passive investing on the one hand and active portfolio management on the other. The true irony of the active/passive debate, is that most investment advisors readily see the benefits of both passive and active investing and most will tell you that they use both when constructing their clients’ portfolios.  Strange then that the financial media and those that would benefit seek to frame the decision as one of either/or.

In light of what we see as a “false choice” between passive or active, we thought it would be instructional to look at performance results for five investment regimes that span the passive/active continuum.  Each approach seeks to gain exposure to international equities but in very different ways.  We define the five investment approaches as follows:

1. Extremely passive: this approach will allocate to a single market cap weighted index that seeks to represent all international (non-US) equities.  We use the MSCI All Country World ex-US index.
2. Passive: this approach divides international equities into two categories; developed and developing markets.  This is perhaps the most common approach taken by advisors when it comes to gaining exposure passively to international equities.  Our analysis assumes a 50/50 allocation between the iShares MSCI EFEA Index ETF (EFA) and the iShares MSCI Emerging Markets Index ETF (EEM).
3. Passive/Active: doesn’t matter what you call it, quasi passive, quasi active, smart passive. The point is that the approach seeks to combine elements of both active and passive investment approaches in one.  Our analysis assumes a 100% allocation to the AlphaClone International Downside Hedged Index (ALFIIX).
4. Active:  taking one step further towards active management we simply take the Morningstar Foreign Large Blend category returns which represents the average return of all active mutual funds in that category.
5. Extremely active:  finally, for the high octane set, we include an “extremely active” category represented by the HFRI Emerging Market (Total Return) Index. The index represents the average returns for hedge funds that invest in foreign emerging markets.

We calculate annualized returns through February 2016 and compare each investment approach across several time horizons.  The results are presented in the chart below – extremely passive is the left most bar (light blue), extremely active is the right most bar (dark grey).

Active vs Passive Approach

Not surprisingly the “extremely active” approach has not done well over the analysis period.  Interestingly however, the “passive” approach that allocates 50/50 to EFA and EEM has done even worse over both the 3 and 5 year periods.  Investors were better off taking an extremely passive approach and allocating to a single market cap weighted index of international equities rather than make an active decision to isolate developed and developing markets or allocate to hedge fund strategies that invested in emerging markets.  The runner up approach was the “active” investment approach.  If you were lucky or skilled enough to have selected and maintained continuous exposure to an active manager who was able to match or beat the average category returns, you did relatively well over the 3 and 5 year periods.  Unfortunately, most investors have demonstrated conclusively that they neither have the skill or luck to consistently select active managers that outperform.

That leaves AlphaClone’s combo approach which continuously scores and selects managers based on their holdings disclosures, thereby solving the “manager selection dilemma” that investors who seek to access active managers so often face.   We then aggregate the high conviction ideas from managers we select and can vary overall market exposure over time – all based on a 100% rules based process.    Over the analysis period, AlphaClone’s passive/active approach added 400 basis points of positive relative performance over the next best methodology over a three year period and 118 points of annual alpha over the next best strategy over a five year period.

Active or passive represents a false choice to investors and their advisors.  A thoughtful combination of both passive and relatively low cost active investment regimes that can leverage the strengths of each while avoiding their respective weaknesses has proven itself over time to be superior to either passive or active strategies on a stand alone basis.  Despite the media hype, even Jack Bogel’s Vanguard agrees (page 12, last paragraph).