Should you go active or passive? Two experts weigh in.
Passive is more cost-effective
by Kin Chin
There’s a clear trend toward passive target-date fund solutions among defined contribution plan sponsors. In the U.S., more than 71% of plans offer TDFs with at least some indexing in the underlying allocation, while 41% follow an all-index strategy—compared with 29% investing in actively managed funds, reports Callan Investments Institute’s 2014 Defined Contribution Trends survey. And here in Canada, more and more sponsors are realizing the benefits of an index approach.
With a passive approach, an investor is simply trying to match general market performance of a benchmark index by buying all (or a representative sample) of the investments in the index— typically a much lower-cost approach than active management.
Read: The future of target-date funds
Among sponsors and members, there’s an increased emphasis on cost containment, driven partly by a lower-return environment where higher fees represent a bigger relative drag on performance. Indexing offers cost efficiencies: fees are lower, and there tends to be lower portfolio turnover, reducing trading costs. Over the long term, the performance advantage of index funds can be significant.
And cost-efficiency isn’t the only reason to go passive. Over the years, on average, active managers — both in the U.S. and Canada — have failed to outperform their respective benchmark consistently over time, after fees, according to the 2014 SPIVA Canada Scorecard. From a plan sponsor’s perspective, selecting the (non-average) manager who can consistently beat the market is like finding the proverbial needle in a haystack. If sponsors can’t predict which active managers will outperform, they’re better off paying attention to factors they can control, such as cost.
A passive approach also benefits the sponsor from a fiduciary perspective. After all, it’s difficult for members to blame a plan sponsor for selecting a low-cost solution with often better-than-average performance versus a universe of funds. In an atmosphere of increasing focus on costs, indexing allows sponsors to mitigate potential liability from investing in a higher-fee — but still underperforming — active fund.
Then there’s the governance factor: it’s easier and more cost-effective for DC plan sponsors to monitor the performance of index funds than active managers. Devoting fewer resources to manager oversight and performance monitoring means sponsors will have greater resources and time available for more strategic activities.
Read: Match your targets to moving markets
From the plan member’s perspective, diversification is a key element of a well-constructed portfolio, and indexing is an efficient way to gain exposure to a broad basket of securities. With index solutions, members can feel comfortable the TDF portfolio will grow with the market, and they don’t need to worry about picking the right manager or the right stocks. As well, indexing will likely achieve broader diversification than a typical active strategy, given that it includes the full universe of securities in a given benchmark.
A passive solution also makes communication with plan members easier. There’s a lot to be said for simply telling members you’re investing in a fund that tracks an index, since it eliminates the need for them to understand the differences between active managers. Also, a plan member can have the best stock-picking manager in the world, but if the asset allocation is suboptimal, that doesn’t matter very much. In a way, indexing de-emphasizes the focus on manager selection and redirects it to asset allocation — where members should be spending more time anyway.
Finally, indexing reduces the risks and costs of manager turnover. Even the best active manager will underperform at least occasionally, and it’s a lot to expect plan members to stay the course and wait for performance to rebound. In a DC plan, replacing underperforming managers can be quite disruptive and costly, with increased complexity in member communications, fund mapping (moving a member’s assets to a new fund) and fees.
Read: New plan members rely on balanced, target date funds
Building a TDF begins with setting the appropriate investment objective, followed by decisions on the fund’s glide path and which asset classes will achieve the optimal risk/return profile. Once the asset classes are chosen, the choice between active versus passive is really an implementation decision following from everything else.
When engaging in the active versus passive debate, it’s important to keep in mind that deciding on the right investing strategy requires a balanced view. And for more and more plan sponsors, that view is leading them to make passive TDF solutions the default choice for their members.
Kin Chin is director, defined contribution investment strategy, with BlackRock Asset Management Canada Ltd.
Active management adds value
by Jonathan Jacob
For individual asset classes, passive management means replicating an industry benchmark, but when it comes to target-date funds, this definition doesn’t apply. Because TDFs have multiple asset classes, investment managers need to make active decisions to determine the asset classes used and their allocation, which changes over time.
Research published in the Financial Analysts Journal has shown that, over any time horizon, asset allocation is the biggest determinant of risk in a portfolio. The performance difference — and risk-adjusted performance difference — between two TDFs is explained more by asset allocation than by the underlying funds in a specific asset class. In choosing a TDF, the asset mix selection and glide path design are the first two considerations; whether the underlying funds are active or passive is a tertiary decision.
Read: Active and passive: A better marriage
Active decisions are made when selecting the asset classes to include in each target date (e.g., 2035). For example, do the TDFs allocate to global equities or use a mix of U.S. and EAFE (Europe, Australia and Southeast Asia) equities? Do they include alternative asset classes (e.g., infrastructure)? If so, what is an appropriate allocation to them? Do the funds use universe bonds or long bonds, or some combination of the two?
Selecting the asset classes involves additional assumptions about expected behaviour (i.e., return and volatility) of each asset class and how each asset class will behave relative to other asset classes (correlations). Again, these are all active decisions tied to the TDF’s asset mix construction.
The defining feature of a TDF is its glide path (the fund’s changing asset allocation over the lifecycle of the member). Therefore, it’s critical for an investment manager to actively consider the appropriate risk exposure for a member early career, mid-career and approaching retirement.
Target date managers use portfolio constraints, such as maximum allocation to risky asset classes, based on the time until retirement. The most common constraint related to risky assets is the maximum allowable exposure to equities. While a higher equity weight throughout the glide path may lead to higher returns in bull markets, it adds a large amount of timing risk to those members in later-dated funds, should a market correction occur within 10 years of their retirement. The financial crisis of 2008/09, for example, led to many hard-working people delaying retirement due to excessive equity exposure. High inflation also has the potential to erode the purchasing power of savings. Throughout a member’s career — particularly as the member nears retirement — a manager can add a constraint to mitigate the impact of high inflation. Also, foreign currencies can create additional volatility, so it might be desirable to add a constraint decreasing exposure to foreign currencies over time.
Read: Hit the mark with target date funds
While managers make active decisions in glide path design for both active and passive TDFs, there are specific benefits that only active managers can provide. For example, active managers can provide access to direct alternatives and other nontraditional strategies that don’t have an equivalent passive option.
There is a misconception that there are true passive alternative investments. But these investments are unable to properly replicate the desirable features of direct alternative asset classes.
For example, the most common benchmark used for the Canadian commercial real estate market is the IPD All Property Index. This benchmark is not investable, so it can’t be replicated through passive management techniques. Common passive vehicles used in real estate include real estate investment trusts (REITs), which are traded on exchanges, leaving price discovery to listed markets. Equity-like volatility ensues, resulting in high correlations to equities. When added to a multi-asset class portfolio, REITs don’t offer the same degree of risk reduction and diversification benefits as direct real estate.
In addition, many alternative asset classes produce long-term sustainable income streams and align with members’ long-term investment horizons. Actively managed TDFs can take advantage of direct alternatives and use them to increase the probability of members achieving their retirement objectives.
Active TDFs can benefit from active risk management by avoiding concentration risk through the identification of factor, sector and security-specific risks, while passive portfolios accept all of these risks and simply invest in companies based on their market capitalization. As a result, passive portfolios acquire all of the risks inherent in the index, its constituents and their respective weights.
Read: An alternative to target date funds
In Canada, this leads to passive portfolios with significant weights in energy and precious metals — market segments that have seen significant declines in the past few years. For example, from September through November of 2014, energy (more than a quarter of the TSX) declined by 23%, at a time when the TSX ex-energy rose by 1.4%. From November 2012 to June 2014, materials (which began the period over 20% of the index weight), declined by 36%, while the TSX ex-materials rose by almost 9%.
Active managers have the ability to adapt their exposure during specific market environments, meaningfully overweight or underweight sectors and use bottom-up selection to add value over the benchmark. When active managers use effective risk management, they can mitigate the TDF’s exposure to market tail events, which can have a significant impact on plan members who are close to retirement.
All target date managers make active decisions in the most critical parts of their TDFs: asset allocation and glide path construction. However, active managers also have the latitude to use the full spectrum of investment options, including direct alternatives, and the ability to actively manage risk within the asset classes. That’s why active TDF managers are better positioned to increase the probability of members achieving their retirement goals.
Jonathan Jacob is senior vice-president, portfolio risk solutions, with Greystone Managed Investments Inc.
Get a PDF of this article.