Revisiting the active versus passive cage fight

The ongoing "cage fight" between active and index managers has a tendency to overshadow some essential tenets of portfolio construction, according to Vanguard investment specialist Mary McLaughlin.

McLaughlin spoke at the Australian Institute of Superannuation Trustees Super Investment Conference, describing the debate as a "mug's game that wasn't going to get resolved in 50 minutes on the Gold Coast."

She noted that while she was representing the "passive" side of the debate, Vanguard actually manages more than US$1 trillion in active money, having launched its first active product in the 1970s.

"For us, indexing and active are just more tools in the toolbox," she said.

She suggested one of the reasons the debate persists is because of internal incentives, arguing that managers are fundamentally trying to convince investors to join "their side," but said that Vanguard can be excluded from this because of its mutual structure.

Fundamentally, she argued, the decision to allocate to active or passive could be represented in a flow chart, where one asks whether they have the resources and expertise necessary to identify outperforming managers. If not, one should allocate 100% to passive; if yes, one should then ask key questions about gross alpha expectation and risk tolerance prior to finding an adequate active-passive mix.

"In this debate, everyone wants to be on the side of the angels, and it is true that the pro-indexing camp does exhibit a certain missionary zeal and does relish painting active managers as fallen angels who started off with good intentions but then got caught up with hubris and the lure of revenue-driven asset gathering," she said.

"On the other side, it used to be that active managers were too angelic, and now the argument has shifted to us being too big, too lazy and, my personal favourite, threatening the very future of capitalism."

Expanding on that latter point and representing the active side, Schroders chief investment officer Greg Cooper said that while "both active and passive have a place in the broader portfolio construction question," the massive flows into indexing strategies is leading to "the danger of cheap and dumb investing."

He said that if "everybody moves into passive, all hell breaks loose" in the market, noting that if all passive money went into broad market cap-based indices, there wouldn't be as much of an issue.

"The problem is when a lot of those flows are going into sub-indices. On a flow-weighted basis, every single one of the top 10 stocks on the S&P 500 is receiving a greater proportion of its daily flow than its market cap would suggest," Cooper said.

"And on the flipside, the stocks further down the market cap spectrum are getting gradually underweighted. If I pick on Amazon, for example, in the last 12 months, Jeff Bezos sold $2 billion worth of stock. Looking at the active managers in the top 10 holders on the register, they've sold around $8 billion of stock. Meanwhile, the passive managers have bought $6 billion. Since that doesn't add up to zero, the difference is probably made up by much smaller investors, particularly individual investors, following the momentum."

This isn't too much of an issue if you're a buy-and-hold investor, he said, but further issues arise when money is moving in and out.

"Flows are clearly becoming distortionary. ETFs are clearly not buy-and-hold, because if you look at the largest ETF in the world, the SPDR S&P 500, it does about $16 billion a day in flow, which represents about 6% of its total value. So over the course of a few weeks, those things are turning over 100% of their value."

Read more: VanguardMary McLaughlinAmazonAustralian Institute of Superannuation Trustees Super Investment ConferenceGold CoastGreg CooperJeff BezosSchrodersSPDR S&P
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