The old “active vs passive” debate is dead – here’s why

This article appeared first in Financial News

As investors grasp the dangers of market concentration and turn increasingly to specialist investment vehicles and private markets, it’s time we acknowledge that active investment management is about far more than stock selection.

Where is the familiar scepticism toward active management? Weren’t active investment strategies, especially in liquid markets like the US, supposed to be facing extinction?

That was only a few years ago, but the debate has moved on by leagues. The binary poles of active and passive are less relevant by the day. For one, there has been an explosion in recent years of passive funds which do not track broad indices: they focus instead on themes, styles, regions or other sub-categories. They may be passive, but the process of using them as building blocks within a portfolio is distinctly active.

Other factors are also driving a re-appraisal of the stereotyped active v passive standoff. For instance, market volatility of recent months has brought home the concentration risk bound up in broad indices, whether these are global or US. Almost three quarters of the MSCI World Index is made up of US companies and just ten stocks, primarily tech, comprise half of that.

To be fair, passive participation in the journey to that concentration has worked well for investors. Since 2010 the S&P500 has produced annual returns of almost 14%. As the dollar strengthened and US equities cemented their dominance, they significantly outperformed other world markets. But the dangers were brought home sharply in April’s sell-off triggered by Trump’s “Liberation Day” tariffs. Complacency rapidly evaporated.

What we’re seeing among investors now is a more deliberate approach, and a need for strategy. In Schroders’ latest Global Investor Insights Survey – conducted among 995 professional investors from around the world representing $67 trillion in assets – 80% of respondents say they are more likely to use actively-managed strategies in the next 12 months. The survey was undertaken in April-May.

Investors now want to build resilience into portfolios, and they’re looking to do it by diversifying across geographies, styles and asset classes. Many are reducing dollar exposure. This is a noteworthy reversal: the previous reflex at times of uncertainty was to view the dollar and US assets as safe havens. Capital is now shifting to Europe, Asia, or emerging markets.

It’s also about style. Confronted with the pitfalls of an index, investors want an approach which is anticipatory or contrarian. For much of the past two decades macro factors (low interest rates, abundant liquidity, US exceptionalism) have lifted all assets. With a backdrop of increased volatility, micro factors (individual companies’ earning resilience, for example) are now coming to the fore. The need to look ahead is more pressing. What lies around the corner? One solution could be a value approach, where underpriced holdings offer a safety margin; others could be thematic, anchored on an industry or trend.

The use of assets is evolving, and growing appetite for private markets is changing the story

Aside from today’s yoyo of US policymaking, there are underlying global problems which will long outlive Trump’s presidency. One is ballooning sovereign debt. This is a major cause of fixed income market uncertainty: yields will be higher, but there will be higher structural volatility.

So where investors seek income, bonds may be the answer – or one part of it. Another eye-catching outcomes of the Global Investor Insight Survey was that private debt and credit alternatives are soaring in popularity. They are now the most attractive assets for investors wanting income.

If a future income solution is one which offers both public and private debt together, that makes the traditional debate between active and passive fade to irrelevance. The same goes for public and private equity.

New technologies will bring the focus back to investors’ needs

Distributed ledger tech, AI and cheaper computing are propelling us towards investment solutions that will be more sophisticated – more investor-specific – than the familiar fund structures of today. Private investors will have tailored portfolios geared around personal goals and dates. Pension funds will have sustainability preferences embedded in portfolio construction. The simplistic poles of passive vs active – far less relevant than the main aim of solving the investor’s problem – don’t belong in this picture.

One swallow doesn’t make a summer, and future capital flows will be the proof of my argument. The rise of passive investing has been a theme of the investment industry for the past 25 years, but it’s been a story shaped by the investment industry, not necessarily by what’s best for investors. Now we’re at a turning point.

How do you see the active vs passive debate evolving in your own work or with your clients? Let’s hear your perspective in the comments 💬.