The Great Target Date Debate: Active or Passive?
MARCH 14, 2017 | The active versus passive debate has dramatically altered the landscape of the investment management industry. Advocates of passive investment strategies laud the perceived benefits of lower management fees. Proponents of active investment strategies point to bottom-up research and risk management as reasons to go active.
Given the growing popularity of passive strategies, the debate has seemingly divided the asset management world into two schools of thought: the new breed who think all investment exposure should be gained through passive strategies and the old guard who still believe in the merits of active investing. But is such a hard line between the two schools of thought really necessary? Is it even appropriate? Why can’t a multi-asset portfolio benefit from both types of strategies—active and passive? In fact, when you remove emotion and introduce research, the benefits of this blended approach become abundantly clear. Empirical evidence shows that the answer to whether an investor should choose an active or passive investment strategy depends largely on the asset class and market environment.
According to “Dunn’s Law,” when an asset class does well, a passive index fund in that asset class does even better and vice versa. In other words, passive is more likely to outperform active when the index return is high and underperform when the index return is negative or more modest (see chart below). Our research has found that this is statistically significant in certain asset classes such as large cap value, but not significant for other asset classes like emerging market equities.
Dunn’s Law exists in part because many active managers, particularly in the large cap equity space, tend to invest outside their index constituents, either by moving lower or higher in market capitalization or adding international exposure in their portfolios. In addition, bottom-up active managers have a general bias towards high quality companies that boast strong balance sheets and consistent or growing earnings. This inherent quality bias becomes a headwind to index-relative performance during strong equity markets, where lower quality, higher beta stocks (typically underrepresented in active portfolios funds) generally tend to outperform their higher-quality counterparts.
For core fixed income strategies, there is less of a debate when it comes to active versus passive. Over long periods of time, active fixed income managers have demonstrated an ability to outperform the index. However, active core fixed income managers tend to overweight credit relative the index in the search for alpha opportunities. As a result of this credit bias, many active core fixed income managers tend to outperform the index during an economic expansion but tend to underperform during an economic contraction, particularly in its initial stages, as they are likely to hold onto credit for too long.
So what does all of this mean for target date strategies? Well, investors in these strategies have an end goal in mind, i.e. the “target date” for when they plan to start withdrawing their money. The time between the initial investment and the target date can be more than 40 years, which will expose investors to a wide range of market environments. Accordingly, a target date manager should have an appropriate arsenal of active and passive investment strategies to choose from.
It’s also important to remember that no target date fund is truly passive. Even target date managers who invest solely in passive investment strategies are forced to make a series of “active” decisions. For example, how much equity exposure should an investor have when he or she is young and accumulating assets for retirement?
The bottom line is that the active versus passive arguments used at the individual asset class level are simply too narrow of a lens for target date funds. In our latest paper, we offer a framework for plan fiduciaries to conduct a more holistic evaluation of target date funds.
Passive equity strategies tend to outperform when markets rally but underperform when markets sell off
Dunn's Law: Three Year Rolling Index Return vs. Index Rank (1999-2016)
Source: Morningstar Direct as of 12/31/2016. Represents Three Year Rolling Index Return vs. Index Rank (1999-2016).
Past performance does not guarantee future results.
All data is as of December 31, 2016. This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) changes in laws and regulations and (4) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.