Published by Brett Carson
Trends are pervasive in our culture, and the investment world is no different. The latest is the move towards passive investing using low-cost ETFs. Essentially, the argument is that nobody can consistently beat the overall market, so you’re better off owning a cheap index fund with the aim of just keeping pace with it. This stands in contrast to active investing where portfolio managers charge higher fees to research and select individual assets with the goal of outpacing market returns. Recently, the passive camp is winning and it’s not even close. According to the Financial Times, just 19% of large-cap mutual fund managers beat their benchmark in 2016, and passive funds grew five times faster than the active management industry in 20161. In fact, passive funds have outperformed active managers six out of the past seven years! Case closed. Game over. Right? I believe that the death of active management has been greatly exaggerated for the following reasons:
Active Versus Passive Management is Cyclical
The fact of the matter is that both styles go in and out of favor. While passive management is currently wearing the crown, it was the active camp that outperformed passive in nine out of 10 years during the 2000-2009 period. During the 1990s, passive bested active seven out of 10 years. Over a longer term, there is no clear winner. Over the past 32 years, active has outperformed 15 times and passive has won 17, according to Morningstar2. In short, investors should allocate to both styles.
Active Strategies Proactively Manage Risk
Most passive investors define risk in a very simple way – volatility. The more volatile an asset or sector is, the more risky it must be. They then allocate their assets across security types (bonds, stocks, real estate, etc.) and sectors (tech, utilities, financials, etc.) based upon its historical volatility. There is no consideration given to the underlying securities held in index ETFs. Most buy that basket of securities blindly without knowing what’s inside. On the other hand, active managers look at risk much more broadly. Not only is volatility considered, but also valuation, technical risk, business and industry risks, macroeconomic factors, among others. Many think active managers’ primary goal is to pick outperforming stocks. Rather, I would argue that they are actively managing risk.
Remember the movie, The Big Short, and the scene where Christian Bale’s character is combing through all the individual loans inside of mortgage-backed securities to identify the bad ones that he wanted to bet against? That’s what active managers do – avoid risky investments (or bet against them in this case). To continue the analogy, passive investors would look at that AAA-rated mortgage-backed security and measure its risk by its historically low volatility, which unfortunately is what a lot of people did.
True Active Managers Can Take Advantage of Market Inefficiencies
Warren Buffett once said, “I’d be a bum on the street with a tin cup if the market was always efficient.” What he means is that through conducting deep research on companies, he can identify situations where stocks are underpriced relative to their intrinsic value. This is another key advantage of true active management – the ability to overweight securities that are undervalued. This stands in contrast to passive strategies that weight the underlying securities by market capitalization, or size. I say “true” because there are quite a few actively managed funds that structure their portfolios to be very similar to that of its benchmark. After charging relatively high fees, these are almost destined to underperform over time. There are pockets of the market that tend to be more inefficient than others (small caps, international), and there are periods of time where the broader market becomes inefficient as well. Unlike passive, active managers can be opportunistic and capitalize on such situations.
The active versus passive debate will rage on, and as history shows, active managers will have their day in the sun once again. My advice is to take a balanced approach and don’t try to time when the next shift occurs.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. No strategy assures success or protects against loss. To determine what is appropriate for you, consult a qualified professional.
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1 Source: https://www.ft.com/content/7f60c1c6-d368-11e6-b06b-680c49b4b4c0?mhq5j=e3
2 Source: https://hkbeta.morningstar.com/ods_images/2015Jun_Morningstar%20Active-Passive%20Barometer.pdf