Few topics are the subject of more lively discussion in the world of Financial Planning than the active v passive debate. For Financial Planners, the matter should be considered at two levels when making the Financial Planning decisions.

The first is at the overall asset allocation level. The question is whether the Financial Planner’s asset allocation model should remain static or be adjusted over time. Some planners and some multi manager funds work on the principle that when viewed over decades the combined performance of a mix of assets will produce a result appropriate for a particular set of investment or risk objectives. Once the model is set, they may regularly rebalance the underlying assets back to that original model. 

This approach may be validated statistically when viewed over very long-term periods but ignores the fact that different asset classes will be at different stages in their cycles. The passive asset allocator would argue that over the long term, perhaps 20 years plus, performance will all smooth out and the investor will achieve the long-term results anticipated by the model. This would suggest, therefore, that it is appropriate to “invest in it and leave it”. However, this may provide little comfort to the client with a 10 year investment horizon whose adviser has placed him into a portfolio with a 10 per cent allocation to property in 2007 at the peak of the property bubble! 

I am not suggesting here that Financial Planners should try to time the markets, guess turning points and frequently switch asset classes into and out of their models. However, I do believe that unquestioning adherence to an asset allocation model set in the past is dangerous and will, inevitably, result in sub-optimal investments for some clients. The second active vs passive decision relates to the selection of the individual funds that make up the model. Unlike the first question on the overall asset allocation, we have the benefit of some past history to guide us. In order to obtain an adequate sample and to examine funds operating in different asset classes over a long time period it is necessary to look to the US mutual fund industry. Looking at the performance over the 27 years ending in 2006 we cover a time period that has spanned several phases in the market cycle including the dot com boom and subsequent collapse. I have looked at the Morningstar data listing the percentage of managers of Active US Large Cap Funds that have outperformed the S&P 500 index and the Active Small Cap Managers outperforming the Russell 2000 index over the period.

If we look only at the performance of the Active Large Cap Managers it would seem to bear out the arguments of the supporters of ‘passive’. In only 7 out of the 27 years sampled did more than 50 per cent of the managers outperform their index. However, in the case of the Small Cap Fund Managers the picture is significantly different with managers outperforming in 16 out of 27 years.

Another factor is that, both Large Cap and Small Cap Fund Managers delivered their best performance relative to their markets in years when the markets performed poorly. This is likely to be due, in part, to the effect of holding cash within active funds for liquidity and to meet redemptions.

The Large Cap managers find it more difficult to outperform their index. In the seven years in which the majority of managers have outperformed the S&P 500, five of these were in years where the market fell or grew by less than 10 per cent. However, in the 11 years in which the Russell 2000 grew by less than 10 per cent, Active Small Cap Managers outperformed the market in 10 out of those 11 years. The Small Cap market is, inevitably, less well researched and less efficient than that containing larger companies. The evidence would seem to suggest that where a market is under researched or inefficient, active management is more likely to outperform the index.

So what does this mean for the Financial Planner? At the overall asset allocation level experience over recent years would indicate that unless the client is investing over very long periods the “set in and leave it” approach to asset allocation models are insufficient. Active management of the overall asset allocation is needed to reflect change to the asset classes and the risk and return that they produce at different points in their cycles. For the majority of investors it makes no sense to adopt a rigidly passive approach.

However, when it comes to the question of whether to select active or passive managers for funds within the various asset classes the results would suggest that there is no single, correct answer. Overall, the active vs passive decision is one that must be approached with an open mind, a clear focus on the risk reward trade off and the costs of particular investments considered.

John Jackson is chief operating officer of Cornelian Asset Managers, Edinburgh.