Active versus Passive: Part II
Title: Active versus Passive: Part II
Date: 05/21/2023
Summary: Whether active managers consistently outperform their benchmark or not
is an empirical issue that must be resolved by looking at their performance
data. The SPIVA scorecard published by Standard & Poor’s reports the percentage
of managers underperforming their benchmark. The report shows jointly these
results suggest that in any of these categories, for a person selecting and
staying with the same active manager, that active manager is likely to
underperform its benchmark. Given that the actively managed funds have a higher
management fee than the passively managed index funds, the SPIVA results raise a
simple question: Why pay a higher fee to underperform in the long run? Score one
for the passive strategy. But does the SPIVA data conclusively prove the case of
favoring a passive investment management strategy over an active management
strategy? Is the case for a passive strategy as strong as this SPIVA data
appears to suggest? In the next few paragraphs, we examine and interpret much of
the SPIVA data. We argue that the passive case is not as strong as it appears to
be.
Economic disturbances generate size cycles that cause changes in the dispersion
of returns and thereby altering the opportunity set of stocks likely to
outperform their index. The popularity of cap-weighted equity indices opens the
door to explore and develop active and cyclical size related strategies. The
reason being that cap weighted indices automatically increase their exposure to
stocks whose prices appreciate and reduce their exposure to stocks whose prices
fall. As a result, one can argue that cap-weighting tends to overweight
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overvalued securities and underweight undervalued ones. This provides an opening
for active portfolio managers. Instead of accessing this market exposure via
traditional cap-weighting, an active manager would use an alternative-weighting,
or construct portfolios that differ from the index or benchmark in order to
increase the portfolio exposure towards certain factors, such as size and style.?
In theory, many of the portfolio built by the active managers preserve the
typical benefits of traditional capitalization based such as broad market
exposure, diversification, and liquidity.
The previous paragraph also raise an interesting issue. The discussion suggests
that the definition of skilled investors as is commonly used is too narrow, it
focuses solely on the investor’s ability to select stocks that outperform their
index or benchmark. But as the saying goes, there is more than one way to skin a
cat. There is more than one way to deliver superior returns relative to the
benchmark. A top-heavy cap weighted index combined with a changing economic
environment that generates size cycles provides the necessary elements to
implement a cyclical strategy that takes advantage of the changing odds of
outperforming an index that is neither random nor reflective of a stock
selection skill.
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