29 Nov The Active vs. Passive Investment Debate
Anthony W. Mariano
The Telluride Association’s Investment Policy Statement, passed at the 2016 Convention dictates that our investment strategy “will utilize both passively and actively managed investments.” A later section states: “The asset allocation will be implemented using both active and passive investment managers. Highly efficient areas of the capital markets will be managed mostly using index funds and other structured strategies (e.g., smart beta, enhanced index, portable alpha).” These brief statements introduce one of the foundational questions and theoretical debates within the Board of Custodians: how willing should we be to make an active investment, and under what circumstances does an active investment make the most sense?
As background, a passive investment strategy, employed by index funds, is designed to capture the growth of the entire market, or relevant asset category. Stocks are not held and traded based on the events of the day, and there is no attempt made to time the market to secure the best returns. A passive strategy is designed to secure for you the market’s returns – no better, no worse. Passive investing is a long-term strategy. An active investment strategy, conversely, is a hands-on approach, that employs an investment manager to make buy or sell decisions, based on market predictions. Active management requires an in-depth analysis of potential investments by managers and relies upon accurate predictions about how particular investments will perform in the future. Active investment is a more high risk strategy.
It is fair to say that because of our long-term investment strategy, the Custodians have a strong preference for passive investments when possible. When the Custodians consider whether to make an active investment in a particular space, there are several factors to consider. The first is consideration of the fees. Actively managed strategies are uniformly more expensive than passive strategies. Active managers have standard manager fees, as well as incentive fees (increased fees in times of the strongest returns). Accordingly, the Custodians need to consider not only what types of returns we expect from an active manager, but whether that strategy is cost-effective when considering the high fees we will need to pay. The second factor we will consider is whether the investment space is appropriate for active management. In some asset classes, an active strategy is the only option. The Custodians then need to consider whether we think it is worthwhile for us to be in that asset category at all. In others, there are passive and active strategies, but the asset class is not so well developed that we believe a passive strategy can confidently secure returns representative of the market. An example is our investment in Templeton Frontier Markets. In considering this investment, the Custodians decided that the frontier markets space was worthy of an investment and that, because particular investments could vary so widely, employing an active manager who could perform in-depth research of investments justified the fees we would need to pay. The final consideration for the Custodians is, once we have decided to make an active investment, which manager to select. This is the most difficult question we face. The Custodians in making such decisions will conduct exploratory phone calls or meetings with the management firms and assess, inter alia, the manager’s prior performance, investment strategy, adherence to strategy, performance against benchmarks, and due diligence. While our review of these issues with potential managers is rigorous, even the best managers on paper – including those managers with strong historical returns – can turn in underwhelming results. Overall, active strategies tend to trail the market, when factoring in fees, and even the best active managers fail to consistently beat the market. This is the key risk assumed with an active strategy.
Because the Custodians view our Endowment with a long time horizon, we have a clear preference for passive investments when possible. That said, we have many active investment across the portfolio, and they play a critical role in securing the returns we need to keep the Endowment strong. But an active investment can be made only after a thorough analysis of the asset class, the fees, and the manager.