March 2019 | Finance
Some call it a debate, while others insist it’s a battle. Since 1975, when Vanguard founder Jack Bogle created the first index mutual fund, investing changed from mostly active management to include passive options. The two have been pitted against each other for almost 45 years.
Wharton Finance Professor Craig MacKinlay, who has been teaching in Investment Strategies and Portfolio Management for thirty years, has seen that battle waged for three decades, and the argument over passive versus active investing continues to be a lively one in the program. MacKinlay says participants are typically split, with half believing strongly in active, and half in passive. “Both sides provide food for thought,” he notes.
In fact, MacKinlay recommends combining both for greater efficiency and diversity. “Active makes sense if you can identify strong managers who can really add value. But that is not easy to do — these managers have to be sufficiently strong to recoup their higher cost.” It’s that higher cost that has many questioning if active is worth it, but MacKinlay says it is, in combination with passive investments.
One key benefit of passive strategies includes exposure to areas of the market where active strategies are difficult to implement successfully. “Some segments of the market, such as large U.S. companies, are heavily researched. Thus, it’s hard to identify companies that are significantly undervalued and to add value through active management. But the stocks of these companies still belong in a diversified portfolio as they are important for overall risk control,” he adds.
MacKinlay says other segments, such as the small cap space and emerging markets, are where an active manager can add value. “These companies and markets tend to be less heavily researched, so a good manager can sometimes find undervalued stocks.” He cautions, though, that finding a good manager does take a lot of work.
In Investment Strategies and Portfolio Management, MacKinlay teaches participants how to better understand strategies by analyzing past returns. “Don’t just rely on the information provided by the manager,” he advises. “Go beyond it and analyze past performance, making inferences on risk and the overall composition of the manager’s strategies.”
An example of one thing to look out for, he says, is active managers who make strong sector bets, such as those who tend to load up on the tech sector. “If that sector experiences a negative shock, your portfolio will take a hit. Those managers may overall be good, but they require you to monitor things carefully.”
Advisors should also be assessed on whether and how they use passive positions. “The line between active and passive has become less clear,” says MacKinlay. For example, smart beta-type strategies appear passive because there are mechanical rules behind them. But those mechanical rules call for buying and selling stocks through time, which is effectively what an active manager does. “Even though the strategies are passive,” he says, “they can also be thought of as active, and active analysis by an advisor using these strategies works quite nicely.”
Overall, he says participants in the program come away with a good feel for portfolio construction techniques and how to evaluate an advisor or consultant. “You learn a framework for analyzing investment strategies — what is driving them and what are the implications. We cover all of the important parts of the investment process, including diversification, asset allocation, and the role of active versus passive management. You need to be able to understand them in order to ask the right questions, and make sure your assets are being appropriately managed.”
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