The issue of passive vs. active investing has been debated for years and generally focuses on risk and return. If fiduciary issues are taken into account however the advantages of a passive approach for CAPs become obvious. Theory, return history, the methodology for CAP asset mix recommendations, and administration are key issues.
Active vs. Passive: The Theory
Much of the theory focuses on work of Brinson, Sharpe, Markowitz and Fama and French. Brinson found that 94% of the variation in total plan return was a result of investment policy. Roger Ibbotson concluded that the impact of asset allocation depends on an individual’s investing style and that for long term passive investors, the asset allocation decision is by far the most important decision. Sharpe concluded that “properly measured, the average actively managed dollar must underperform the average passively managed dollar net of cost.” Markowitz argued that investors should consider both risk and return and use an optimizer to build mean variance efficient portfolios. Fama described why market prices are always efficient hence investors cannot beat the market in the long term. Dunn’s law is also interesting: “when an asset class does relatively well, an index fund in that class does even better’.’
DC members are viewed as long term investors: asset allocation and diversification are emphasized.
The value added from active management has also been challenged. Jane Li recently concluded that, “on average, active managers provided some downside protection in bear markets … but gave up some potential in bull markets”. Morningstar’s Ben Johnson concludes that “an active manager’s odds of consistently besting the market are slim, the odds of selecting a regular market-beater slimmer, and the costs of active management, on average wash out the benefits”. Over the last decade Canadian actively managed funds have fared poorly” and “relative underperformance has been consistent across asset classes” (Vanguard). In the US it was argued that “Active managers did not beat the market when performance was adjusted for risk” (Active Managers’ Market-beating Claims Debunked), In Canada it was concluded that “Canadian actively managed funds have fared poorly, on average, vs. Index benchmarks “ and “relative underperformance has been consistent across asset classes and sub asset classes…” (Vanguard: The case for indexing: Canada). Instances of active fund managers who are effectively “closet” indexers but charge active management fees have also been an issue.
CAP members are not encouraged to churn their investments or focus on tactical investment approaches: the average CAP member is generally an unsophisticated, uninvolved, long term investor. Return and risk performance are therefore important fiduciary issues and must be judged after fees (i.e.; the impact on members’ asset accumulations over time).
Financial institutions usually provide risk profiling and asset mix recommendations for CAP members. The methodology used to determine the asset mixes likely utilizes a mean – a mean variance efficient portfolio approach based on index returns. Given the use of index returns in developing CAP asset mix recommendation it follows that using index funds in a CAP would be a prudent approach to minimizing deviations in returns and risk.
From a fiduciary, administration and performance perspective a passive approach has many advantages, including:
— The fact that general member investment education and communications is simplified
— It is also simpler to explain the investment options to members and trustees
— Fund manager fees paid by members for index funds will be lower than they are for active funds
— Diversification within an asset or sub-asset class is ensured
— Style and sector rotation occurs automatically over time in passive funds
— Index funds are automatically in sync with record keeper asset mix recommendations
— Monitoring return and risk performance is simplified
— Explaining volatility is less of an issue and also simpler to do
— Passive balanced funds, asset allocation funds and target date funds are available
— The time and cost of administration including pension committee and trustee oversight should be lower
Index funds can also present challenges. The administrator may want to consider different indexing methods which are discussed in a recent Canadian Investment Review article ((R)evoltion In Indexing Methods) and explains different types of indexing that could be considered. In addition, ETFs, in their simplest form, could be considered. Fees, while less of an issue, still require constant monitoring. And although governance is simpler, a strong governance framework is still required.
The combination of research and returns, after fees, present a compelling argument for a passive approach for CAPs. From a fiduciary perspective, potential risks appear be lower and members, over the long term, would be better or as well off. In most cases a passive approach presents an effective and prudent approach for CAP sponsors. Given these advantages it seems odd that a passive approach is not more common.