Active vs passive - is there room for both approaches?
The Big Short is by no means a manual to investing but it came to mind as I pondered the ongoing “passive v active” debate.
In the (better) book and movie, it is one of the few works of art that makes a real stab at trying to get under the skin of what investing is.
It’s certainly a Tinseltown story arc: unfancied, socially awkward financial genius earns billions by betting against a “sure thing” and in doing so puts one over on powerful financial institutions and the rating agencies.
For those of you who’ve not read Michael Lewis’s absorbing book (recommend) or seen its cinematic treatment, it’s worth your time.
Active vs passive
And one aspect still stands out in regard to the active v passive theme. It’s the description of the main protagonist burning the midnight oil to examine each individual mortgage contract of the hundreds which made up each investment, known as a collateralised debt obligation (CDO).
His persistence and diligence uncovered the flaw in these instruments which was one of the key reasons behind the credit crunch. For the most part, the concealed peril was that the prospect of returns were built on sand.
He found these securities, created by bundling together mortgages, were effectively worthless as the underlying mortgages had been lent to people with no hope of making regular payments. There was no extra cash being generated.
So he invested in the products created to insure against CDO’s failing, credit default swaps, and made billions when the US subprime market eventually crashed in 2007, triggering the credit crisis.
It’s a colourful example but does illustrate what is a misunderstood term. I see this as an accessible parable about active management, albeit in high finance, but it involves rigorous, pro-active research on the underlying value of an investment.
And when I see the latest headlines about why passive offers a more cost-effective route to returns than the active model, it’s one vignette that comes to mind.
Another, which may not be so obvious but worth remarking on, is that even passive investing requires an active - and important - decision, namely, which index an investor should track?
Room for both
In my view, there is room for both approaches depending on your appetite for risk, cost and ultimate objective.
Most can see the merit in lowering investment management costs for the benefit of the pensioners who rely on a fund to pay for their retirement and there’s a place for it.
Anyone who follows this will also tell you that the passive model can bury true value. The argument (for the uninitiated) is that index tracker funds don’t fully reflect what an individual stock is worth - just the weight of money invested on the basis that they buy groups of stocks at certain proportions at current prices.
It would also mean that less time and money would be spent on interrogating the company behind the investment, which can also mean not just an unrealised opportunity but hidden peril.
And to take it a step further, if everyone bought only passive funds, there would effectively cease to be a market as buyers and sellers would no longer set a fair market price.
Theoretically diverting but also a practical concern for investors, personal or pension scheme, because a passive strategy could simply miss something really worth investing in.
It’s also worth mentioning that the man who devised unit trusts, which gave rise to the “passive” label, Vanguard founder Jack Bogle, also made his company the world’s fourth largest active manager.
Value to be found
Which brings me to my closing point, which is that there’s always room for those whose expertise has exposed real value by doggedly examining the financial fundamentals.
Perhaps Hollywood can’t be relied on to depict the process accurately (after all, few would plan a trip to the movies for that) but does nod to a wider truth.
The ability and vision to assess, soberly and sensibly, the strength of what underpins an investment remains important.
Those in search of higher returns - and able to bear the appropriate fees for doing so - will always consider active investing. That’s because there is always value to be found.