Active and passive: A better marriage

In today’s investing world, the active versus passive debate can be reminiscent of a rocky marriage, with each party arguing about who’s right. Yet, rather than quarreling over which approach is better, it’s useful to step back and look at the bigger picture. Like any good marriage, while there can be differences of opinion, a degree of compromise can go a long way towards reaching a fitting outcome and finding a balanced approach.

Comparing active and passive investing

Active management is beneficial when investment professionals — through their experience in bear and bull markets — can find opportunities through picking individual securities that index funds may be heavily overweight in or have overlooked completely. Many active portfolio managers stick to a disciplined and proprietary security selection strategy to generate alpha and manage downside risk.

Read: Is it getting harder to find alpha?

Passive investing has risen in popularity recently for several reasons, including lower fees often associated with index funds or passive exchange-traded funds. For these products, the index is simply replicated with little differentiation from the market, resulting in any broad losses or gains essentially being replicated.

Sometimes defined contribution plans approach their decision as a binary choice, choosing either active or passive management. Of course, these decisions are not mutually exclusive, and often the best route is for plan sponsors to focus on creating the best performance outcomes net of fees while managing risk, which can be achieved by blending both approaches.

It doesn’t have to be an either/or decision

There’s a lot more that goes into building a multi-asset portfolio than choosing active or passive strategies. A balanced portfolio can include equities, fixed income, real estate and other investments, requiring conscious decisions about the approach to take.

Read: Management fees need to improve, say institutional investors

Plan sponsors (or their advisors) often benefit from active management solutions when they believe in a specific asset class (for example, a Canadian small-cap equity or a global fixed income strategy). Within active portfolios, managers can implement high-conviction views to provide a potential source of alpha that index funds generally do not afford. Active solutions can also help where the index is difficult to replicate or is narrow in scope, like unconstrained fixed income strategies.

Equally, passive investing can play a pivotal role where plan sponsors have little conviction in a particular asset class or are seeking tactical exposure. These types of solutions can be selected where sponsors or their service providers are attempting to create precise exposure, like investing in a single country or sector.

Read: How smart beta can help with de-risking

In our view, multi-asset institutional portfolios should not be totally active or passive because it’s not a proposition of either/or, rather both can have a place.

Working together

As in life, it’s important to take a balanced approach, which should lead to a better understanding of each other’s perspectives—ultimately resulting in a longer-lasting, more harmonious partnership and hopefully, improved investment outcomes.

Matthew Williams is head of defined contribution with Franklin Templeton Institutional, part of Franklin Templeton Investments Corp.