Active managers used to dominate the investment landscape, selecting individual securities based on company-specific data. They relied on financial statements to identify overpriced or underpriced companies, and fundamental analysis was the name of the game.
Then modern portfolio theory and the capital asset pricing model (CAPM) in the 1950s and 1960s popularised portfolio construction to ‘passively’ track a market-capitalisation-weighted index. According to CAPM, an asset’s beta – its sensitivity to overall market risk – could capture the information needed to build an efficient market portfolio that priced in all expected returns. No need for active managers and their fundamental analysis. Or so some would say.
But active and passive investing are evolving, and with this evolution come new ways to use company-specific information to drive returns.
Active management is a spectrum, not a binary with passive management
Beyond binary
The traditional divide between active and passive management is losing clarity. Passive investments typically refer to mutual funds and exchange-traded funds (ETFs) that track a market-capitalisation-weighted index, offering broad market exposure at a low cost. In contrast, active funds are based on an investment manager’s security selection and strategy, and are generally designed to outperform a benchmark by exploiting market inefficiencies. Yet many new investment products do not fit neatly into either category – they lie somewhere in between.
Take smart beta products, for example. These funds track an index, but use alternative weighting strategies. Some strategies, like fundamental weighting, match the list of securities in a cap-weighted index but adjust each asset’s weight according to company fundamentals such as revenue, operating income, book value or dividends. This is why smart beta funds are considered hybrid strategies – they ‘passively’ track an index but use metrics from active management to adjust investors’ exposure to the index.
The reliability of reporting impacts how index investors implement factor-based strategies
Today, factors like momentum, quality, dividend yield and low volatility are commonly used to capture return drivers, and these factors are then packaged into smart beta funds and other factor-based investment strategies and products.
Many of these factors are measured using company-specific data. For instance, the value factor looks at book-to-price ratios, price-to-earnings ratios, cashflow yields, earnings yields, net assets and other measures to capture excess return from undervalued stocks. And the quality factor captures excess returns of stocks with superior financial performance, strong fundamentals and stable cashflows by looking at returns on equity, investments, accruals ratios and financial leverage.
The accuracy, completeness and reliability of company reporting directly impacts how effectively index investors can implement smart beta and other factor-based strategies. Viewing active management as a spectrum spanning index-based investment strategies rather than as a binary with passive management shows how company reports and metrics will remain relevant amid the rise in index investing.
Reliable reporting
Investors are increasingly looking for portfolios tailored to their individual goals, values or tax needs. Customised portfolios often include smart beta or other index products that track specific themes, industries or regions.
Direct indexing takes this a step further, allowing investors (via investment advisers) to buy and hold the individual securities underlying an index in a separately managed account. Advisers can then adjust company holdings to reflect client preferences, such as personal values or tax considerations. Yet again, we see active decisions made on top of index tracking.
Investing is evolving to be more personalised and data focused
Curating personalised portfolios using unreliable or incomplete financial and corporate data would be self-defeating. Decisions like excluding companies based on ESG factors or adjusting asset weights based on book-to-price ratios depend on accurate corporate data. Retail investors can now customise their index portfolios using company-specific information, and we expect the demand for more personalised investments will only grow.
Evolving landscape
Despite the growth of index investing, pure active management remains dominant globally. According to CFA Institute research, equity index funds and ETFs represent almost half of global equity fund assets under management, driven largely by US funds. For non-equity asset classes, including bond markets, active funds remain dominant with approximately four times the assets under management of index funds.
AI amplifies the potential impacts of reliable (or unreliable) financial reporting
Yet pure active management is evolving too, with managers increasingly using data-driven techniques that leverage artificial intelligence and machine learning to refine their strategies. These methods heighten the demand for company data, both structured and unstructured, and amplify the potential impacts of reliable (or unreliable) financial reporting.
