On the other side of the debate, people who advocate active management often believe strongly that low account balances require the added value (or alpha) that a dedicated manager can provide. After all, according to the 2007 Fidelity Retirement Index, Canadians are on track to replace just half of their pre-retirement incomes. Fidelity’s U.S. recordkeeping data, covering 13,000 plans and 10 million participants, reveals that the average 40- to 44-year-old participant has an average salary of US$86,711 and an average account balance of US$69,460—nowhere near enough to generate adequate retirement income. The argument goes, then, that even a small amount of alpha can help close the funding gap.
Active management proponents also point to the fact that many DB plans have been shifting from passive to active mandates. With long-term bond yields stubbornly low—hovering at around 4%—and long-term equity return expectations in the single digits, the classic 60/40 asset allocation won’t achieve DB return targets of 8.5% to 9%. Plan sponsors may be hesitant to increase their equity allocations because that may expose them to greater volatility, but they are willing to take on alpha risk to boost their return potential. As a result, 89% of Canadian assets in DB plans are actively managed today, and 47% of those plans are considering or likely to increase their active risk. It’s a potentially challenging fiduciary position for plan sponsors when they embrace active management on the DB side while choosing passive management for the DC side.
Indexing has its own challenges. Some asset classes are simply too expensive to replicate passively. Others are simply unavailable for indexing—high yield and emerging market debt are just two examples—removing a valuable source of diversification for participants. Finally, passive strategies aren’t a guarantee of index returns and could still exhibit tracking error as they stray from market returns, which could translate into risk without any accompanying reward.
Meanwhile, there is compelling empirical evidence that institutional money managers have historically added value. Over the 10 years ending on Sept. 30, 2007, the median active Canadian equity manager (not the best) beat the index by 0.91%. In U.S. equities, the active manager advantage over the same time frame was 0.94%, and in international equities, it was 2.07%. For both, this is more than enough to cover management fees. Active managers have added alpha over most historical time periods, even when you look at rolling three-year returns to remove end-date sensitivity.
Following this decade’s Wall Street investigations and the subsequent separation of research and investment banking activities, there is now less sell-side analyst coverage. It’s easier for active managers to get an information edge again, making it easier for them to achieve that desired alpha. Furthermore, today’s active managers have the advantage of new tools at their disposal to reduce cash drag by “equitizing” cash with exchange-traded funds, futures and swaps, and by modeling redemption patterns more accurately. The decimalization of trades and electronic trading platforms are helping them reduce transaction costs.
There’s no question that the passive versus active debate will continue. The key for plan sponsors is to choose the approach that suits their needs and the requirements of their participants.
Peter Chiappinelli is the senior-vice president, investment strategy and asset allocation at Pyramis Global Advisors, a Fidelity Investments Company.
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