The decision to invest actively or passively in a market must be based on the structure of that market and the indexes that represent it, not on the historical performance of active fund managers in that market, according to a new research paper from Russell Investments.

Russell’s director of consulting and advisory services in Australasia, Greg Liddell, says there are a multitude of reasons why active fund managers might outperfom or underperfom in a given market, but this alone does not constitute a compelling case for or against passive management.

Rather, “it needs an understanding of the structure of markets and the structure of benchmarks,” Liddell says.

The Russell paper, When should you choose an alternative to passive investing?, authored by Don Ezra, Russell’s co-chair of global consulting, and Geoff Warren, a senior lecturer at Australian National University, attempts to give investors a logical framework to use to decide when it’s appropriate to use active management.

Liddell says the starting point for any asset class should be that unless there’s a compelling reason to do otherwise, investors should invest passively.  The paper sets out five key reasons for why it may be appropriate to invest actively instead:

Reason 1: There is no readily replicable index

Reason 2: The passive index is at odds with the investor’s objectives

Reason 3: The standard passive index is constructed inefficiently

Reason 4: The investment environment favours active management

Reason 5: Skilled managers can be identified

Where a market does not have a readily replicable index, Russell argues that the decision to use an alternative to passive – that is, an active manager – is obvious.

But in other cases, one of the reasons might give an investor an “initial preference for an alternative”, but there are other considerations that have to be taken into account.

For example, a passive index might be at odds with an investor’s objectives.

“The most obvious one is when you’re specifically trying to hedge a liability, or a basket of liabilities,” Liddell says. Then, there may be an initial preference to invest actively, but the investor has to weigh up other issues such as whether the potential benefit of investing actively outweighs the cost.
Liddell says the Russell paper is the first of a planned series. A second paper, due to be published shortly, will examine how the decision-making framework set out in the first paper applies to markets in practice, including Australian markets.

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