The passive investors have been winning, recently surpassing active.
I believe that making an ‘all-or-nothing’ active vs passive decision is not optimal. You can do both, but not in the way it’s typically done.
The fact that massive amounts of capital are going into passive is evidence that passive investors are adopting a new story that at the moment feels and sounds good. But this is exactly the same process that got them into active investing in the first place. Going ‘all passive’ now is another form of return chasing. Given enough time, these investors will be switching to something else in the future.
To un-bury the lead:
Instead of picking active versus passive, blend the two together.
Blending is not making some allocation to passive, and some to active.
Blending is doing both inside each strategy. It takes a shift in perspective.
Active Passive Blend 2.0
If you are a traditional asset manager, adviser or consultant, this might sound crazy at first. To adopt “Blend 2.0” takes a shift in perspective: from asset manager to asset owner.
For all the talk about alignment, asset managers and asset owners care about different outcomes. There are obvious differences such as an asset managers’ focus on raising assets, product manufacturing, higher fees and limited liquidity. But the less obvious difference is the fact that they see return and risk differently.
As an asset owner, you care about long-run compounded dollar return with survivable crash risk.
The fact that a portion of the return comes from alpha and a portion from beta is less important than their sum.
The fact that a portion of the risk comes from factors and a portion from residual tracking error is less important than the drawdown and the risk of giving up.
The fact that there are strategies with great Sharpe ratios or amazing relative returns is less relevant than the investor’s ability to allocate a significant portion of their capital, earn sufficient total return and not give up during drawdowns (see more here and here).
To achieve the asset owner’s objective, why not give active alphas and passive betas an equal chance to contribute over time to the total return?
When you blend active and passive well and stop caring about beating the benchmark over short periods of time, you get diversification from multiple sources (passive and active) and the conviction that makes investing sustainable.
In “Blend 2.0”, the total return might be coming from beta alone for a while. Then, as it usually does, alpha shows up with a short but powerful boost. In asset management, such an active product would not be celebrated where consistency is being oversold. But as an asset owner, your objective is met.
As an extra benefit, by being properly active, you can ironically become a better passive investor because you have the necessary conviction to stay invested without constantly second guessing the direction of the underlying beta.
At the same time, by selectively choosing passive betas that are attractive from a total return perspective, you become a more patient active investor because during the inevitable alpha dry-spells, your portfolio is still compounding at a decent total return coming from beta.
As a result, not only do you meet the total return objective, but over time you outperform most peers in dollar-weighted terms. Importantly, you outperform the version of yourself that is trying to use only passive strategies which you won’t be able to hold on to forever because a new story or risk will eventually show up and grab your attention.
At Two Centuries, we design our strategies with asset owners in mind and apply an active / passive blend in all of our approaches.