One of the primary decisions investors and their advisors are faced with in the portfolio construction process is the type of investment approach – active or passive – to employ. Is there value to be added in hiring active managers, or should a portfolio be passively constructed in order to simply gain the desired market exposures in a cost-efficient manner? Or perhaps a superior outcome can be achieved through a “core/satellite” approach, in which the components of the allocation representing the more efficient market segments are passively invested while active managers are selected for the satellite exposures where inefficiencies may be more prevalent. If so, which asset classes might best be designated as “passive” and which ones “active”? To add complexity, if a decision is made to employ some element of active management, the investor and advisor must then select specific managers to comprise those allocations.
Over the years, there has been a significant amount of research conducted on the active vs. passive question. The debate has generally boiled down to being a referendum on the merits of the efficient market theory (EMT), which posits that since market prices instantaneously react to the knowledge and expectations of all investors, it is impossible to systematically outperform the benchmark consistently. Adherents of EMT typically favor passive management and employ ETFs, index funds and other passive strategies in the portfolio construction process. On the other side of the debate are those that point to the long-term success of certain active managers such as Warren Buffett, Peter Lynch and John Templeton as evidence that markets are not efficient and that active management can indeed add value.
Conclusions from the results of a recent study on this topic: (1) certain Morningstar categories exhibit incidence of manager skill over time, and are therefore candidates for active management; (2) the alphas of the skilled group of managers are not only statistically, but also economically significant; (3) the incidence of manager skill is different for foreign and domestic equities across various economic environments; and (4) in terms of manager selection within categories designated as active, the best dimensions that predict future manager performance are the previous period’s active return, expense ratio and capture ratio.
Overall, our results tend to support the core/satellite approach to portfolio construction. The core (more efficient) categories such as those within the domestic large cap equity segment warrant passive allocation, while the satellite (less efficient) categories such as domestic small cap and international developed and emerging markets are good candidates for active management.
