The explosion of ETFs in terms of assets under management, as well as the sheer number of offerings, has brought the debate between active versus passive management to the centre of wealth management discussions.
Does an adviser use low cost indexes to invest client assets? Or hire portfolio managers who attempt to outperform the broader market?
The increasing use of actively managed ETFs, alongside mutual funds that track indexes, has further blurred the boundaries for advisers. While the active versus passive debate frames the question as simply a binary choice, the best way to look at it is a bit more nuanced, writes Jordan Waldrep, principal and chief investment officer at TrueMark Investments.
What exactly is ‘the market’?
Let’s start with the biggest problem with the debate: the obsession with ‘the market’.
Advisers refer to ‘the market’ all the time, often meaning the S&P 500, but that is just one index trying to capture what is happening in the large-cap equity space. It is put together by a committee that is trying to capture the most established companies in any industry.
There are rules, but many of them are flexible. In a real sense, the S&P 500 is actively managed by a committee.
An important aspect of the construction and rebalancing of the S&P 500 is that there are lots of names that are excluded from the index.
If you look at the S&P 500, it includes about 500 companies at any given time, hence the name. The number of large companies that are excluded from that list is a much longer.
The smallest S&P 500 company, as of 9 February 2020, was Alliance Data Systems with a market cap of $1.6bn (£, €). There are 1,600 US-domiciled companies with a market cap that size or larger meaning that fewer than one in three are in the S&P 500.
Many of these are dynamic growing companies with excellent prospects that just haven’t made the cut yet for whatever reason.
If you are an investor looking for general large-cap exposure in the US, a widely available S&P 500 ETF will likely deliver the exposure you want. When you are talking about broad large-cap exposure, the winners and losers in the fight for market share have pretty much already been sorted out for most of the index.
But what about when things aren’t sorted out yet?
Innovation offers a counterexample. Innovative companies, cutting-edge businesses and new industries are often not being captured by passive indexing designed to capture broader exposure.
Almost everything we view today as a basic part of modern life was at one point a cutting-edge technology. Canned foods, trains, refrigeration, cars, plastics and PCs each dramatically changed our way of life and the way the economy operated at one time or another.
This process of cutting-edge innovation progressing into a staple of life has played out time and time again – it wouldn’t be a stretch to say that today’s most innovative businesses will likely be viewed the same way eventually.
The case for active management
In our opinion, active management really shines in segments of the market where the winners and losers have not been determined yet, particularly in rapidly growing industries.
These nascent industries are popping up all the time, and they are the fertile ground from which innovative businesses grow in our economic system.
When a nascent industry emerges, it usually results in hundreds of companies vying to win market share. They compete and over time and you usually have somewhere from three to five winners, depending on the nature of the space.
In time, this number will often be winnowed down to one or two, as lesser winners are acquired by larger companies or merge to stay competitive. You hear about these winners because they often become household names and may eventually join the S&P 500 Index, but you rarely hear about the hundreds of new companies in nascent industries that fail.
It is an active manager’s job to understand a nascent industry, to work with experts in the field, and to identify which companies are believed legitimate contenders to take market share, as well as which companies are pretenders being swept along in the growth of a nascent industry.
Winners may deliver extraordinary returns to investors over time and losers will often go bankrupt. Unlike in established industries, this is a situation where diversification kills and passive indexes do not effectively capture the positive market dynamics.
Mix it up
As with most things, the correct answer on the debate between active and passive isn’t black and white, but involves shades of grey.
Both active and passive management can serve important roles in investors’ respective portfolios.
Passive management, like that of the S&P 500, is designed to deliver broad large cap equity exposure.
Active management can key in on nascent, developing markets, where the winners and losers of the space are not yet clear.
By blending passive and active investment management styles, investors may be well-positioned to harness the growth of established businesses as well as dynamic new industries at the same time.
This article was written for International Adviser by Jordan Waldrep, principal and chief investment officer at TrueMark Investments