Most people who don’t earn their money in the professional investment world are unaware that there is a heated debate over which investment approach is better: active or passive?
What is active investing?
It might best be described as an attempt to apply human intelligence to find “good deals” in the financial markets. Active managers try to select attractive stocks to move into or out of markets or market industries. Their objective is to make a profit, and, often without intention, to do better than they would have done if they simply accepted average market returns. In pursuing their objectives, active managers search out information they believe to be valuable that could give them an information advantage. That can be talking to suppliers or clients of a company whose stock they analyse or valuation comparisons with industry peers. Active management encompasses hundreds of methods, and includes fundamental analysis, technical analysis, and macroeconomic analysis, all having in common an attempt to determine profitable future investment trends.
What is passive investing?
Also known as a buy-and-hold or couch potato strategy, passive investing requires good initial research and patience.
Passive investment management makes no attempt to distinguish attractive from unattractive securities, or forecast securities prices, or time markets and market sectors. Index products (e.g. Dow Jones Industrial Index or the FTSE-Index) are the ultimate investment tools. Like active investors, they also want to make a profit, but accept the average returns an asset classes produces. Passive investors make little or no use of the information active investors seek out as they don’t believe it will add any value. Instead, they allocate assets based upon long-term historical data delineating probable asset class risks and returns, diversify widely within and across asset classes, and maintain allocations long-term through periodic rebalancing of asset classes.
Which works best?
Results from broad research are clear and indisputable: Active investment management is an appealing mirage which substantially boosts costs and decreases returns compared to properly designed passive portfolios. Most active fund manager underperform not only after costs, but shockingly even before.
When two people quarrel, a third rejoices.
Whilst the debate between active and passive investing is still on-going, there has emerged a third way to invest in stocks which only recently has become more broadly discussed: Factor Investing. A factor can be thought of as any characteristic relating to a stock that is important in explaining their returns and risk. There are three main categories of factors today: macroeconomic (e.g. inflation), statistical, and fundamental (price/earnings ratio). Arguably the most widely used factors today are fundamental factors. Fundamental factors capture stock characteristics like valuation ratios such as Price-to-Earnings, Price-to-Book, to name a few. You will find such factors in the “success formulas” of most investment legends on our platform. The most popular factors are value, size, momentum, low-volatility, quality and high yield while not all of them are really working well.
Factors have their roots in the academic literature (the oldest and most well-known model of stock returns is the so called Capital Asset Pricing Model (CAPM) by Jack Treynor in 1961). With this model academics tried to explain why an active fund manager outperformed or underperformed a benchmark index.
Investment legends such as Buffett, Graham, O’Shaughnessy or Templeton mostly invest by using and combining such factors (sometimes implicitly) to achieve their superior results. Being labelled as active managers they are in reality factor investors and are bridging the two opposing worlds.
On the one hand they can be called active as they buy stocks when the factor criteria are all met and sell stocks when they are not met anymore. But as they do this in a very systematic, disciplined and rule-based approach, they are also called passive.
Is factor investing then a free lunch?
Multiple empirical studies show that these factors have exhibited excess returns above the market. Eugene Fama and Kenneth French, Nobel laureates in economic science, demonstrated in a study conducted in 1992 for the period from July 1962 to December 1990 that for example the average high book-to-market portfolio (cheap) earned +1.63% monthly returns compared to +0.64% for the average low book-to-market (expensive) portfolios. Creating a portfolio with the right factors can therefore systematically outperform the market.
A key element of factor investing however is factor cyclicality. While factors have exhibited excess risk-adjusted returns over long time periods as seen above, over short horizons factors exhibit significant cyclicality, including periods of underperformance.
The graph on the right shows that each of the factors has experienced a minimum of a consecutive two-to-three year period of underperformance. Some factors historically have undergone even longer periods. Thus, there is no free lunch attached to factor investing and the key is the right mix.
Factor investing is neither active nor passive in the traditional sense but it combines the flexibility to adjust stocks over the course of the year (active) with the systematic mechanical implementation according to the predefined rules (passive).
The keys for factor investing are
a) To combine the right factors in a smart way to offset each others weaknesses (see chart on the right),
b) To have a long enough time horizon to digest periods of temporary underperformance and
c) The discipline to stick with the strategy and not abandon it at the worst moment in time.
This is the first post in a series we call Expert Insights. These posts will take you deeper into various investment topics. Many posts will be made by meetinvest Co-Founder Michel Jacquemai as well as guest posts by other investment experts.