The core focus of the active versus passive management debate is an analysis of the value added after fees by active managers compared to a benchmark. Noting that you can't invest in a benchmark, passive investment options are used, for example an index fund or ETF, that aim to replicate benchmark returns for a fee.
Considering this, an analysis of active versus passive approaches should focus on the relative returns of the two alternatives, not of the benchmark per se. This analysis should also include issues such as risk and tax.
The purpose of this discussion is to consider the issue of risk.
Risk can be defined many ways, and few people seem to share a common understanding of it. From an active management perspective, risk is often considered on a relative basis. For example, the risk that an investment may perform poorly compared to an index fund or ETF.
A simple framework for retail investors to understand risk
Risk management is a dimension of active management not often discussed, especially with retail investors, due to its perceived complexity. However, the following is an outline of a simple, integrated approach to determine whether investment risks are:
- recognised and understood
- rational and taken on intentionally, and
- rewarded (every risk should have a commensurate long-term reward potential).
To illustrate this framework, let’s look at the Global Fixed Income sector and why it may not make sense from a risk perspective alone to invest in an investment approach that aims to replicate the benchmark.
The Global Aggregate Bond Index is the most widely followed bond index in the world and is the major benchmark against which global bond managers are measured. Unlike equity benchmarks where the more successful and profitable a company is, the more it grows in size and the larger its weighting in the benchmark becomes, global bond indices could be said to work in reverse.
The largest constituents of the Global Aggregate Bond Index are those countries or regions that issue the most debt: the United States, Japan and the Euro. It could also be argued that they are among the least sound long term financial credits, partly based on the amount of outstanding debt they have on issue. In this case does it make sense to follow the benchmark via an index strategy just because it can be accessed cheaply?
What are the risks of investing in this benchmark approach? Using the framework above, we can identify the risks:
1. Is the risk recognised by investors? At a retail investor level, the answer is likely to be no. Many investors are unlikely to be aware of the composition of the benchmark, and in particular its significant concentration risk. In the Global Aggregate Benchmark, the top three issuers represent over 90% of the benchmark.
2. Is the risk rational? Diversification is one of the basic strategies for reducing risk. A compelling case could be made that the majority of investors would not intend to invest 90% of a portfolio in just three issuers. The significant growth of absolute return fixed income strategies and the shift away from benchmark-aware global fixed income strategies supports this.
3. Is the risk rewarded? In the current environment, yields on ten-year US treasuries are 2.6% and on Japanese bonds 0.6%. That is, an investor lends the US and Japanese governments money for ten years and receives just 2.6% or 0.6% return. It would not appear that the risk is being rewarded. Add to this the widely held view that after a 30-year bull market in bonds, the only way is up for bond yields, and the potential loss of capital value for those currently holding bonds becomes significant, so there’s even less appeal to invest in either absolute or relative fixed income options.
Investor expectations of performance
In looking at risk from an active management perspective, ineffective risk management becomes evident in the gap between investor expectations of performance relative to a benchmark and actual performance. An active manager might be happy to outperform an index by a margin, even if delivering negative returns to the investor. We don’t need to look too far back (2008) to see that ineffective risk management can lead to disappointment. There are a number of examples from that period where underestimating the risks of Collateralized Debt Obligations (CDO’s) or municipal bonds left many investors in active strategies suffering significant losses in both absolute and relative terms. In these instances the risks were not recognised, rational or rewarded.
The purpose here is not to dismiss the case for active or passive approaches as there are roles for both, but rather to broaden the discussion to include risk as a necessary and integral part of any active versus passive debate, especially for retail investors.
Jim McKay is Director of Advisory Services at Franklin Templeton Investments.