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More on The Active Versus Passive Debate

by | Insights, Uncategorized

The Stampede From Active Management To Passive Investments

1. The Rationale for “Active” Investing

2. The Rationale for “Passive” Investing

3. What You Really Need to Know About Active vs. Passive

4. Takeaways From Today’s Active vs. Passive Discussion

Overview

Over the last decade, we have seen a massive shift on the part of investors away from so-called “actively-managed” mutual funds and exchange-traded funds (ETFs) and into so-called “passively-managed” funds – also referred to as “index” funds.

Over the three years ended August 31 alone, investors added nearly $400 billion to passive mutual funds and ETFs while draining more than $400 billion from active funds, according to data from Morningstar, Inc. That’s huge!

While the majority of mutual funds continues to be of the active-management style, that is rapidly changing. The question is whether the stampede from actively-managed to passively-managed funds is a good thing or not.

The Rationale for “Active” Investing

Actively-managed funds have a designated manager (usually a management team) that makes the day-to-day decisions on which stocks to own. The frequency of trading varies widely. The goal of active management is to equal or beat a particular benchmark (such as the S&P 500 Index or others).

Active managers believe that the markets are inefficient, and as such, anomalies and irregularities in the capital markets can be exploited by those with skill and insight. Prices react to information slowly enough to allow skillful investors to systematically outperform the market, they believe.

Analyzing market trends, the economy, company-specific factors, etc., active managers are constantly searching out information and gathering insights to help them make their investment decisions. Many have their own complex stock selection and trading systems to implement their investment ideas, all with the ultimate goal of outperforming the market.

Active management strategies vary widely from manager to manager. These strategies can include fundamental analysis, technical analysis, quantitative analysis and macroeconomic analysis, just to name a few. Active managers may, or may not, be fully-invested at all times. Some of the assets may be parked in cash – ( a money marketfund) from time to time.

The Rationale for “Passive” Investing

Passive management, or “indexing,” is an investment approach based on investing in exactly the same securities, and in the same proportions, as an index such as the Dow Jones Industrial Average, the S&P 500 or others.

It is called “passive” because the fund managers don’t make decisions about which securities to buy and sell; the managers merely construct their portfolios to be as identical as possible to the index they are tracking.  The managers’ goal is to replicate the performance of an index as closely as possible.

Passive investors believe that market prices are generally fair and quickly reflect all the relevant information available.

They also believe that consistently outperforming the market for the professional and small investor alike is difficult, if not impossible. Therefore, passive managers do not try to beat the market, but only to match its performance.

Passively-managed funds, almost by definition, have lower fees and expenses than their actively-managed brethren. It is also important to know that passively-managed funds are usually fully invested at all times. If the stock market goes down, passive funds lose just as much as the market, or more due to fees and expenses.

Remember that the S&P 500 Index lost over 50% in 2007-2009, and most passive funds experienced similar losses. Keep in mind that it takes a 100% gain to recover from a 50% loss. That can take years!

What You Really Need to Know About Active vs. Passive

A debate about the two approaches has been ongoing since the early 1970s. I will tell you that there is no “pat” answer to this question, although I will explain my own preference as we go along today.

Each side can make a strong logical case to support their arguments, although in many cases, the support is due to different belief systems, much like opposing political parties. However, each approach has advantages and disadvantages that should be considered.

The goal of active managers is 1) to meet or exceed their benchmark index, and 2) to lose less than the market during down-trending periods. Keep that in mind as we proceed.

As for active management, the most important thing you need to know is that the vast majority of active managers have under-performed their benchmark indexes in recent years. Depending on whose numbers you read, some 60% to 66% of active managers have failed to match or exceed their benchmarks the last several years.

Their primary excuse is that the stock market has skyrocketed in recent years, and active management strategies shouldn’t be expected to keep up in such an unusual environment. Really? Are you buying that? I didn’t think so.

Just as important, many active managers experienced their worst losses in their histories during the severe bear market in late 2007-early 2009. The idea that active managers can get you out of the market, or at least minimize losses, blew-up big-time for many in 2008. Some lost almost or just as much as the S&P 500, which as you know was down over 50%.

Here is what you should take away from this discussion on active managers. While 60-66% of active managers have failed to meet or exceed their benchmarks in recent years, that leaves over one-third that did. The question is, how do YOU find the successful active managers?

Unfortunately, most investors don’t have access to (or are unwilling to pay for) sophisticated services that track and rank active managers. Many of the most successful active managers don’t advertise widely (they don’t need to), so you’re not likely to hear about them. The average investor’s odds of finding the truly successful active managers are sadly quite low.

Now let’s turn to the most important thing you should understand about passive strategies. As I noted earlier, most passive managers are at or near 100% invested at all times. What this means is that in a market downturn, passive investors are going to experience the whole loss or maybe even more due to fees and expenses.

Put differently, this means that the millions of investors who have herded into passive strategies over the last few years will very likely regret that decision in the next serious downward correction or bear market. Unfortunately, when investors move en masse, it is very often the wrong decision. Think “contrary opinion” theory.

Takeaways From Today’s Active vs. Passive Discussion

The fact is, there are plenty of successful active managers and funds out there. Unfortunately, there are probably twice as many that are mediocre or worse. The question is, do you have the tools to separate the good ones from the bad ones? The answer for most investors is NO.

The bottom line is, if one can consistently identify the successful active managers, as we believe we can, then there is no question that I would recommend actively-managed strategies over passively-managed strategies.

I’ll take my chances with successful active managers over passive managers that are sure to get clobbered in the next serious downward correction or bear market. The current stampede into passive investments is a mistake in my opinion.