The futility of the active versus passive debate

FROM time to time, we get this question about the way we manage wealth for our clients: Why should clients pay you an ongoing advisory fee if you take a “passive” instead of an “active” approach to investing?

In the investment world, an active investment strategy is one where the investment managers switch from one asset class/country/region/theme to another, or pick securities based on short-term market forecasts to try to get higher-than-market returns (also known as alpha).

This is the opposite of passive investment managers who buy a basket of securities that simply tracks an index and do not make frequent changes due to short-term views of the markets. In doing so, they will only get market returns. Because of the term passive, it seems to suggest that it is an inferior, lazy approach with nothing much being done once an investment is made. Because passive managers do not give excess returns over the markets, there is no value added. Perhaps one should just DIY and avoid paying extra fees to wealth advisers.

But to debate which is the better approach without first determining the type of clients we are investing for and what problems we are trying to solve for them is like putting the cart before the horse – and therefore futile.

In my firm, our clients are primarily family stewards whose dominant focus is to take care of their families. They are conservative in their personal and professional lives. They want us to help them reach their non-negotiable life events (such as retirement) without compromising their shorter-term life goals (such as taking a one-year sabbatical to pursue a worthwhile cause with a non-profit organisation).

Therefore, they are not looking to maximise their investment returns but rather, want the reliability and sufficiency of the returns to meet their needs. To achieve that, the better approach would surely be based on evidence rather than trying to outguess the market.

I have written numerous articles in this column that while there are some active managers who can beat the markets, evidence shows that most fail to do so. Even those who do beat the market cannot do so consistently.

Therefore, the evidence-based way to get returns is via globally-diversified portfolios using passive low-cost index and systematic investments, and staying invested for the long term instead of making frequent short-term adjustments based on guesses – no matter how smart they may seem. But for this “passive” approach to work, there are three areas that need to be active.

Wealth planning

Our goal is to ensure that our clients’ wealth plans will help them achieve their life events and goals with higher certainty. We need to work out the amount of funds and the suitable asset allocation for their portfolios. The future expected returns of the stock markets need to be properly estimated.

One model that investment analysts use is the Ibbotson-Chen Earnings Model developed by Peng Chen (who is currently my firm’s senior adviser) and Roger G Ibbotson, which was published in the Financial Analyst Journal in 2003 and adopted as a fundamental reading and testing for the Chartered Financial Analyst examination.

The model breaks down the overall equity returns into various components, examines the historical data and scrutinises each component in a forward-looking setting to come up with the final estimate. Because the model is scientifically developed, there is a basis for us to make adjustments when necessary throughout the lifetime of our clients because the markets are always changing. This process can hardly be described as passive.

Investment management

While we do not actively manage our portfolios in ways that the industry defines it, it does not mean nothing is done on an ongoing basis behind the scenes. We hold quarterly meetings with the fund managers whom we work with, and actively check the portfolios’ investment behaviours – including but not limited to the returns and risks – to make sure that they are working the way they should.

In addition, we continue to scour for suitable instruments that we can use to improve the investment experience for clients even though we do not always include every instrument we looked at. An example would be that we recently incorporated exchange-traded funds tracking China government bonds into some portfolios, but we did not add Treasury inflation protection securities even though we studied them.

The portfolios are also actively rebalanced on a regular basis or whenever needed, so that they continue to reflect their correct asset allocation. I do not think anyone can say we are passive in this area.

Investor psychology

While we know from evidence that staying invested for the long term is the most reliable way to get sufficient returns, we know that in the short run, there will be plenty of noise and volatility – which in turn can cause investors to feel uncomfortable and sell out prematurely.

If they do so, they are then unable to capture the returns they need, and could even lose capital. Thus, in addition to proper cashflow planning before and during retirement for clients – which is customised to their individual circumstances – we also actively execute a turbulence management plan. This includes investor education from the time clients are onboarded and throughout their lifetime, and also a series of communication and handholding activities through market volatility.

As a result of our “active management”, we hardly had clients who sold in panic in 2022 when markets were uncertain. Instead, many clients invested more. This allowed them to capture the returns when markets started recovering since the beginning of 2023.

So, whenever I am asked whether we use the active or passive approach to investing, my answer is that we are evidence-based. We are passive in areas where evidence shows us that it is better to be passive, and active in areas where we cannot afford to be passive.

This philosophy is born out of our experiences managing money through many crises. We know what works and what does not work. This approach may not suit every investor. From our experience, it is most suitable for those who are not looking to maximise their returns but are looking for a reliable way to get sufficient returns to achieve their non-negotiable life events and goals.

As an individual investor, you need to decide what type you are and the best approach that suits you.

The writer is chief executive of Providend, South-east Asia’s first fee-only comprehensive wealth advisory firm. He can be contacted at chris_tan@providend.com