HFR Podcast: Indexing the Future – Active Meets Passive
Are active and passive investing two sides of the same coin?
In this episode of the HFR Podcast, S. Aneeqa Aqeel speaks with Austin Guy of Northern Trust about the increasingly blurred line between active and passive investing. They explore how indexing itself involves active decisions, why benchmark selection is critical, and the growing challenge of outperforming concentrated indices like the S&P 500.
Austin also highlights the importance of robust, transparent benchmarks as demonstrated by HFR’s leadership in developing consistent hedge fund index methodologies, as well as where active management can still add value and how to distinguish true skill from excess returns. As technology advances, the conversation underscores a clear trend: the convergence of active and passive into a more flexible, precision-driven investment approach.
Keywords
active investing, passive investing, indexing, benchmark selection, portfolio management, market innovation, hedge funds, private markets, index creation, investment strategies
Guest Bio
Austin Guy is a Senior Vice President and Senior Client Portfolio Manager within Institutional Asset Management at Northern Trust where he develops global solutions for institutional investors. Austin has comprehensive experience of passive indexing as well as quantitative active and factor-based investing and research. Prior to his current role, Austin was a Quantitative Equity and Fixed Income Strategist, developing and delivering comprehensive investment solutions and insights across the spectrum of index, engineered, and active equity strategies. Prior to that role, Austin was a member of the Index Services team, where he focused on developing and managing quantitative index solutions. Austin received a B.S. in Finance from the Marquette University and an M.S. in Finance, with honors, from Depaul University. Austin has earned the right to use the Chartered Financial Analyst (CFA) designation and is a member of the CFA Institute.
Chapters
00:00 Introduction to Austin Guy
00:40 Quotes on Indexing and Active Management
01:17 Active and Passive Management in the Investment Toolbox
01:47 The Complexity and Growth of Passive Investing
02:41 Defining Passive Investing and Its Overlap with Active Decisions
03:08 Using Indices to Express Active Views
03:50 Active Management’s Use of Indices
04:26 Creating Benchmarks and Outperformance Opportunities
05:18 Active Management in Small Caps and Fixed Income
06:36 Challenges of Benchmark Concentration and Market Leadership
08:05 Measuring Manager Skill and Dispersion in Indexes
08:52 Impact of Market Volatility on Active Management
09:15 Benchmarks for Alternative Assets
10:10 Innovations in Indexing and Future Trends
11:50 The Next 5-10 Years of Indexing and Investment Strategies
Transcript
S. Aneeqa Aqeel
Welcome back to the HFR Podcast. My guest today is Austin Guy, a Senior Vice President and Senior Client Portfolio Manager with Institutional Asset Management at Northern Trust. He develops global solutions and insights for institutional investors, and he has comprehensive experience of passive indexing, as well as quantitative, active, and factor-based investing and research. Austin, a very warm welcome to you on the HFR Podcast.
Austin Guy
Wow, thanks, Aneeqa. I appreciate the opportunity to be here.
S. Aneeqa Aqeel
So I want to start off with a couple of quotes. One is from William Sharpe of the Sharpe ratio. He said this in 2002, “indexing is a dull, boring way to be a better investor than many of your friends.” And the second quote from a newsletter that I follow on another podcast, “active management defined broadly can mean index fund selection, factor ETFs, or the selection of an active manager.” So I think that really captures the crux of my first question to you, which is can active and passive management styles sit side by side in a manager’s toolbox? And in what situations is active management appropriate when our passive benchmark tracking investments preferable and how much do they overlap today?
Austin Guy
That’s a great question. I think no offense to Bill Sharpe, who’s certainly on the Mount Rushmore of academic investing. I think almost the second quote answers whether or not the first quote by William Sharpe is accurate. The long and short of it is index investing is active. There is a series of active decisions that go into every part of choosing whether you’re actively managing, doing passive investment, and then all the decisions that go into choosing the right benchmarks.
And we’ve seen this play out and be exacerbated over the last several years, given all the events that we’ve seen in the marketplace. And if we step back and look at the growth of passive, which sits between probably 50 to 70 % of assets right now, and that’s grown from high single digits 15 to 20 years ago, it’s gotten more complex, and it’s become more important. Now the question is, how do you define passive investing?
Traditionally, the answer is, well, it’s replicating a very large broad benchmark using market capitalization weighting. And there’s a good theory to think about, well, passive is no longer that when you’re looking at specific sectors or styles, are you making a passive decision or are you taking an active decision away from a cap weighting? Because anytime you’re deviating from a broad benchmark, you are making some sort of decision. And this is where it does start to get interesting, is there’s an argument to be made that those are more active-like decisions than passive. To me, passive management is one where the objective of the portfolio manager is to replicate a benchmark, not seek any sort of excess return. The latter part of your question was, how might these two things work together in a portfolio? What we’re seeing is that institutional and retail investors are certainly using index funds in the passive management style to express active views, take overweights on certain themes, sectors, market segments or countries, but do it in a very cost effective, transparent way by using passive investing. So there’s a really healthy intersection of these two. The benefits we’ve seen is that the S&P500 as index has been a top quartile portfolio going back a number of decades. It’s been really hard to beat and there’s a lot of reasons we can explore of why that is. But I don’t think the traditional construct of active versus passive is necessarily the way I think we should think about it in today’s environment.
S. Aneeqa Aqeel
That’s a great answer. So if I were to think about indexing more as an art today, and I’ve again, I’ve heard it said that you can create an index for anything nowadays, right? People are almost scornful when they say that. How does active management then utilize indices? And would you counter that view?
Austin Guy
Yeah, so active management can use indices and to your point, you can create an index in any which way and it’s buyer beware at that point. There are seemingly limitless ways to create an index and that doesn’t always carry good things. mean, even standard indexes have so much variation between them that people often miss. And there’s the assumption that an S&P500 is going to deliver the same performance as a Russell 1000 because they’re designed both to track what we would consider to be
US large cap equities. And they haven’t. Over long periods of time, returns have generally been the same, but year over year, there’s quite a bit of variation. Even those two indexes have between 30 and 70 basis points of annualized tracking error. The opportunity for active management is to find benchmarks that they can outperform. And a perfect example of that is something like the Russell 2000. That benchmark has a lot of non-earning companies in it.
Going back the last several years, almost 40 % of that benchmark was made up of non-earner companies, which means those companies don’t have enough interest earnings to pay off those interest debts going forward. We call those zombie companies. They’re the walking dead. So a really easy way for an active manager to outperform, skill aside, is just to take a quality bias and own the higher, more profitable companies relative to the Russell 2000.
Now, the interesting corollary to that is you could also outperform the Russell 2000 simply by investing in the S&P600, which has a quality screen embedded in the methodology. The results for active management in small caps, when you look at swapping in the S&P 6 as a performance benchmark, obviously become much worse. We saw this within fixed income as well. Prior to COVID, interest rates being in a secular decline, active fixed income managers benefited greatly from simply being longer duration and taking more credit risk. And when things changed, all of those active managers that were simply relying on that positioning often underperformed when things got a little more tricky, more volatile, and interest rates became more sensitive in the portfolios. And so discerning manager skill is different than excess returns and how you measure that in the benchmark selection has a lot to do with that.
S. Aneeqa Aqeel
Absolutely. So thinking about benchmark selection’s interesting because the S&P500, for instance, is hard to beat. But the concentration of capital in the Magnificent 7 today almost makes it not really representative of the entire US market, right? So how does active management outperform or tackle that benchmark, especially given the higher concentration risk return combination now.
Austin Guy
It’s going to be very hard. And we’ve seen that when you have seven companies that are 40 % of that index and they’ve been contributing more than 100 % of the index returns as an active manager, you’re paid to take active share and being underweight those companies has made it obviously very, very hard to outperform. I think, as I said before, there is a difference though, in measuring manager skill by simply looking at excess returns. So if a manager were to select a basket of S&P500 companies in a concentrated portfolio that had a beta of 1.2, the S&P goes up 10%, their portfolio should go up 12%. Although that 2 % is explained entirely by the equity beta. If that manager outperforms by 2.5%, we might say that some part of that 50 basis points is true manager skill. And so skill is defined by things like security selection, but also timing.
There’s ample dispersion within US indexes, for example. If you look going back to the Russell 3000 since 1984, about 70 % of the companies annually have a return that’s more or less greater than or equal to or greater than or less than 10% relative to the index. So if the index returns 20%, more than 70 % of the companies have either returned 30 % or greater or 10 % or less.
That’s really fertile ground for active managers. So despite the narrow breadth and the leadership, there’s still opportunity to take active share and outperform these indexes. It’s certainly harder. And the changing shape of volatility has made it even harder. What we’ve experienced since GFC is more volatility shocks, both in equities and fixed income.
So shocks tend to be more clustered and greater in magnitude. We’re seeing really steep drawdowns, but also really rapid recoveries. So that timing element of skill becomes a little bit harder. So managers who have sort of been at the table and washed away over years, that group is getting smaller. And what we’re seeing institutionally is active risk being deployed to those managers that have proven to take really concentrated portfolios in unique areas of the marketplace, delivering on themes, using big data, whatever it is, you can still outperform, although it’s less likely in the broad market segments, it’s more likely in certain countries like China or in emerging markets or in small caps.
S. Aneeqa Aqeel
So I wonder if you can extend that argument to benchmark replication in hedge funds and alternatives at all, or how is that different? What are the things to watch out for?
Austin Guy
Yeah, so I think if we think about the benchmarking in general, benchmarks need to be transparent, marketable, investable. They need to be appropriate. What I’ve seen in the industry, and HFR is a great example of this, is creating very consistent methodologies for hedge fund indexes. The move, I think, towards the next stage is continuing to standardize those methodologies. That’s going to enable the next phase, which is how do we build products that the retail audience can invest in to give them access to these underlying managers. Now, there is going to be a big difference between a direct investment in a hedge fund and an investment in the ETF that’s tracking a hedge fund index. At this point in time, either doing this through a total return swap or a derivative is one way to do that. But most commonly, that product is going to use a subset of publicly traded funds that have characteristics that replicate that hedge fund benchmark. Now, is that entirely appropriate for that investor? That’s something you have to determine. Is it transparent? It is. Is it measurable? It is. So it does check a lot of the boxes. And I think the industry itself will probably figure out a way to do this because there’s demand from defined contribution funds, target date funds to bring in alternatives. And a first step is do we have a benchmark, a product that we can look to build these? And so I think we’re in a good spotin the industry, but I’m very curious to see how we take that next step and build the products off of those indexes.
S. Aneeqa Aqeel
Okay, so final question for you, are some innovations and indexing, excuse me, what are some innovations and indexing that are underway and in the pipeline that you would like to talk about?
Austin Guy
Sure. So I think the most exciting thing about indexing is you’re pointing to is it’s not a product. It’s really a technology and a tool. And we’ve kind of alluded to the fact that just because you can basically create an index of anything doesn’t mean that you should. Although the opportunity set for investors is tremendous. 10 or 15 years ago, the only way to get something not off the shelf or customized, bespoke to a client’s objectives was often to find an active manager who was willing to do that for you.
Today, we can build an index to screen out companies, themes, sectors, countries, regions, incorporate alpha forecasts and signals, sustainability considerations, and all do it in a very cost effective risk controlled way that’s bespoke specific to a client. And I think about, as we’ve talked about, extending that into private markets as sort of the next frontier of where indexing can go. I think the real question investors are asking now is what happens if my index or the S&P500 doesn’t deliver 15 % but delivers 5 % and I have a 7 % return target. Active manager may still be challenged and instead of returning maybe 12 % they’re delivering 2%. And so how important is it then to think about innovation with indexing and adding excess return or alpha on top of that? And so we’re seeing concepts like enhanced indexing come back into the marketplaces, adding small amounts of alpha to what’s typically the largest portion of your portfolio is very, very meaningful.
Active risk on high conviction fundamental active managers is important. You need diversified sources of risk, but I think the market and the environment is going to reward precision with active risk over prediction. And so we’ve seen resilience with quantitative and systematic approaches that are index-like, but tilt towards style factors or idiosyncratic risk controlled, but also seek alpha. And so this growing area in the middle between traditionally peer passive and fundamental active, I think is only going to expand. The technology is enabling us to build unique solutions that are index-like or passive-like. But if we start where we started back at the top, it’s going to really blur the lines between those two of what do we consider to be passive investing? And so the next five to 10 years, should the market environment change, it’s going to push and pull products in a very different way. I do think we’ll see that middle ground grow and the blurring of active passive in that way.
S. Aneeqa Aqeel
Fantastic. Thank you so much for sharing all of your insight. It’s immensely thought provoking and wonderful to have you on the show. Thank you for joining us.
Austin Guy
Thanks, Aneeqa. Thanks for having me. It’s been a pleasure.
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