It is no secret that passive investing has made big inroads in snagging increased market share the past decade or so. The argument goes something like this: “Over the past umpteen years the “Average” manager has been unable to beat his or her benchmark, so why pay high fees for sub-par performance?” Sounds pretty simple, right? Maybe not.
Let’s start by looking at the “average manager”. A simple screen for non-index US equity funds shows that there are nearly 2000 US equity mutual funds available for investment. If we look at the median returns over time of this group, there are almost a thousand managers who are better than the average over a period of 5 years. So it appears we have a fighting chance of finding a manager who is above average. In fact there are quite a few who are in the upper quartile a great deal of the time and even some that have handily beaten the benchmarks. With all the data that is now available, we can quickly locate managers who are superior over multiple trailing periods.
There are 2 problems with this way of thinking, say the passive stalwarts. First of all, even the best managers occasionally endure 3-5 year periods where they fall out of the top 50% of all managers. In other words, as we screen for managers with relatively stellar records, we should be aware that past performance is no guarantee of future performance. It is also possible that our new manager is about to hit a rough patch. The counterpunch to this argument is that a good consultant should be able to do a deeper dive into manager due diligence, examining everything from ownership and corporate structure to culture and investment process to hunt for clues as to future performance. You don’t have to be a genius to compare historical investment returns, but it does take some insightful research to divine how a particular manage or style will do going forward.
OK say the indexers, but what about beating the benchmark? Over the past 5 years, the record for most active managers has been abysmal. In the 5 years ended on March 31, 2018, an index fund such as SPY, a proxy for the S&P 500 index, has topped all but 15% of active large cap managers.
Well, the activists say, active decisions to preserve capital (by holding cash for example or by shifting to more defensive investments) will provide better downside protection in a correction or bear market. Since we haven’t had a meaningful calendar year decline for 10 years now, it’s no wonder that passive investing has done better than most over that period. However we are currently experiencing a correction in stock prices and in the past 3 months, indeed, we have seen almost as many active managers beat their benchmark as not. This viewpoint implies that active and passive management are cyclical in terms of their efficacy.
It is true that there are a number of management groups out there that are not very good at ever beating the benchmark. They are sometimes referred to as “benchmark huggers”. Absent the courage of their convictions (or a game-winning playbook), they invest to mimic the benchmark (intentionally or unintentionally), as closely as possible, only to have their high fees knock them out of the game. This is typical of many of the “me too” product lines coming out of insurance companies, brokerage firms and banks. These are asset gatherers, not investors. How can one tell? One useful guide is to look at active share, which measures the deviation of a portfolio from benchmark composition. As well, informed conversations with a manager may reveal (or not) the passion and conviction that most successful managers have. And exhaustive research on portfolio attribution (what worked or didn’t and why) is crucial to selecting winning managers.
Regarding managers’ recent underperformance, much has also been made of the higher correlation between returns on individual stocks. Whether it is a product of the surge in index investing or a result of the “risk on/ risk off” mentality that took hold a few years back, stock prices had experienced a prolonged period of high correlation. At the extreme, if all stocks move together, index investing can’t be beat. Therefore during this recent period of high correlation, it became very difficult for active managers. However the tide has now turned, with correlations trending downward, a hopeful sign for active management.
And the regime of super low interest rates may be impacting the active vs. passive scorecard. As traditional savers (think bonds, CDs etc.) were shut out by the paltry level of interest rates, many moved into equity index funds (as was the Fed’s intention according to the MIT school of thought led by Ben Bernanke). The surge in index investing may have enjoyed the self-fulfilling prophecy effect by investing new dollars in proportion to market caps. What will happen as investors become more comfortable with bond yields and savings rates? We may soon find out, and there will be nowhere to hide in index funds.
There is a place for passive investing in most portfolios. In portfolio construction, there is a need for exposure to both beta (the risk inherent in the market) and alpha (the contribution of manager skill). Alpha is more readily attained in the less efficient asset classes, such as small cap stocks, international equities and alternative investments. This has led many to use passive investments as part of their exposure to the more efficient asset classes, such as large cap US stocks.
While passive investing has been on a roll, this too may pass for any of the number of reasons mentioned above. Of course it would be nice and easy for investors if index investing dominated over the long haul. But as Roger McGuinn of the Byrds once wrote, “To everything, there is a season” (turn, turn, turn).