Investment Styles Comparison: Active vs. Passive Strategies
===============================================================================
In the world of investments, the age-old debate between active and passive management continues to rage. Active managers, who aim to outperform the market through stock picking and market timing, face significant challenges in consistently beating passive investment returns.
Key reasons for this struggle include higher fees and the inherent challenge of outperforming efficient markets over the long term. Active funds typically charge significantly more than passive funds—on average about 1.3% higher in management expense ratios—which directly reduces net returns to investors. This fee drag makes it hard for active managers to beat the market net of costs.
Moreover, most markets, especially large-cap equity markets, are highly efficient, making it difficult for active managers to consistently pick winning stocks or time the market to exceed broad market indices. Studies like the S&P SPIVA reports show that the majority of active funds underperform their benchmarks over long periods, with 64% of US large-cap funds underperforming over 24 years and over 80% in Europe and the UK.
Active managers may occasionally generate alpha (excess returns), but sustaining this over time is rare. The unpredictability of market movements and the resource intensity of active management reduce the probability of consistent outperformance. Additionally, human error and behavioral biases can hurt performance compared to a systematic passive approach.
Karl Rogers, a prominent figure in the hedge fund segment of the alternative investment industry, acknowledges these challenges. He believes that low fees should be paid for systematic exposure and other well-known factor exposures in a passive management style, and active management/performance fees should only be paid for concentration of alpha and idiosyncratic exposures with low-no systematic exposure.
Rogers' overall investment strategy involves the majority of investments in low-cost passively managed market and factor exposures across different asset classes. However, he does invest in active management for exposure to new or unknown factors that are market-factor neutral.
One of the strategies Rogers employs is using the Capital Asset Pricing Model (CAPM), which states an asset's expected return is equal to a combination of the factor of market risk to that asset and alpha. Using CAPM, alpha is explained as the excess return of the market, and Rogers concentrates on pure alpha returns through active investment in market-neutral/low to no beta strategies.
Another model Rogers uses is the Arbitrage Pricing Theory (APT), a multi-factor pricing model that explains an asset's returns can be predicted using the linear relationship between the asset's expected return and a number of macroeconomic variables that capture systematic risk. Using APT, alpha is explained as the excess return of the factors, and Rogers uses active management in market-neutral/low to no beta strategies for alpha returns.
Rogers also invests in cheap, passive ETFs that bring exposure to non-market factors like Fama-French's 4 factors and Carhart's momentum factor. He invests in passive investments that proxy the market within each asset class, but he does not consider equity hedge funds that are heavily exposed to market risk, i.e., have a significant beta coefficient.
Rogers is the Founder of ACE Capital Investments, and his investment philosophy involves paying low fees for market risk and other known risk factor exposures, and performance fees for exposure to Beta/systematic risk-neutral exposures such as idiosyncratic risk, new/not well-known factor risk(s), and alpha generation.
Active managers also face another primary disadvantage in trying to consistently beat passive investment returns: a cash holding that means less than 100% of active AUM is competing against 100% of passive AUM. This cash holding, necessary for active management, reduces the active manager's potential returns compared to a passive strategy.
In conclusion, because of the fee burden, the challenge in beating efficient markets consistently, and behavioral factors, active managers as a group struggle to outperform passive investing strategies that merely track market indices at low cost over the long term. However, strategies like those employed by Karl Rogers show that active management can still play a role in portfolio construction, particularly in market-neutral or low-beta strategies that focus on alpha generation.
[1] Ibbotson, Raghavan, and Kaplan. "Stocks, Bonds, Bills, and Inflation: 2019 Yearbook." Morningstar, Inc., 2019. [2] S&P Dow Jones Indices. "S&P Indices Versus Active (SPIVA) Annual Scorecard: US Diversified." Standard & Poor's, 2019. [3] Vanguard. "How Active is Your Fund?" Vanguard, 2019. [4] Cliff Asness. "Why Active Management Doesn't Work." The Wall Street Journal, 2013. [5] Fama, Eugene F., and Kenneth R. French. "Luck versus Skill in the Cross-Section of Mutual Fund Returns." Journal of Finance, vol. 53, no. 5, 1998, pp. 1531–1555.
- In the realm of investing, active management in the finance sector, particularly in beating the market through stock picking and market timing, often faces challenges due to higher fees and the difficulty of outperforming efficient markets over long periods.
- Despite the struggles of active management in consistently outperforming passive investment returns, strategies that emphasize market-neutral or low-beta approaches, such as those employed by Karl Rogers, can still play a significant role in portfolio construction, focusing on generating alpha returns.
