The investment industry is embroiled in a “great debate” concerning which investment philosophy is best: active vs. passive management. The debate concerns how the building blocks (asset classes) that make up the portfolio are constructed. The raging question is whether investment advisors should use passive index funds and ETFs as the building blocks or whether it is better to use more active sub-managers or products.
But this “great debate” is a head fake. It misses the elephant in the room. The main issue is NOT whether the investment advisor used active vs. passive building blocks. The issue is whether the investment advisor’s subsequent strategic and tactical allocation decisions with those building blocks, be they active building blocks or passive ones, were cumulatively beneficial or harmful to the investor’s risk and return experience. We have known for decades that the primary driver of the portfolio’s eventual performance is the relative weighting of the asset classes the investment advisor selects, not whether the allocation decisions are implemented using active vs. passive products or sub-managers. An investment advisor could build a “bad” portfolio using only passive products in the same way another advisor could build a “good” portfolio using actively managed products. (Good and bad in the prior sentence is defined by the risk and return characteristics of the portfolio over an extended holding period.)
If 90% of the results will flow from the investment advisor’s strategic and tactical allocation decisions, shouldn’t the effort be placed on measuring the effect of these decisions rather than whether the investment manager uses active or passive building blocks in their implementation? Shouldn’t 90% of investors’ time be spent developing governance processes to test whether their investment advisors’ strategic and tactical allocation decisions were beneficial or not, irrespective of whether active vs. passive products/managers were used to implement these decisions?
If the capital owner is a Business Manager or other fiduciary (individual trustee, ERISA trustee, endowment trustee, et cetera), this practice of establishing several key performance indicators to test the effectiveness of the investment manager’s strategic and tactical decisions is central to accomplishing the fiduciary’s oversight duties.
Following is a link to a white paper that explains these benchmarking best practices.