April 15, 2014
Active or Passive?
In a recent Wall Street Journal (WSJ) article, the debate over whether to use active or passive investments was addressed. The conclusion was just use both! Let’s take a look at the five reasons they give to defend this neutral stance and see if they hold up to scrutiny.
1. Use index funds for efficient markets, and active funds for others.
The rationale is that it is hard for active managers to beat the index in efficient markets like the S&P 500, but where they thrive is in less efficient markets like domestic small cap and international stocks.
This sounds reasonable; however, the facts don’t back it up. According to the 2013 SPIVA study, which ranks active managers against their benchmark, the majority of active managers underperformed passive investments in 21 out of 22 categories over the 5-year period ending 12/31/13. Some conclusions from the study:
- 79.4% of active managers underperformed large US stocks (S&P 500)
- 74.8% of active managers underperformed small US stocks (Russell 2000)
- 71% of active managers underperformed international stocks (EAFE)
- 80% underperformed the “less-efficient” emerging markets asset class
Clearly, the evidence suggests that active strategies are no more likely to outperform in less efficient markets.
2. Keep the door open for beating the market.
The article says, “Index mutual funds and exchange-traded funds offer a low-cost, tax-efficient way of matching broad market returns—which a large percentage of active managers can’t seem to do.” However, they say there is an emotional element to investing you have to consider. People want to think they can beat the market and don’t want to settle for benchmark returns.
Well, sometimes I like to think I could play golf professionally, but then reality sets in as I wake up! Look at the stats from above; you are playing a loser’s game if you keep trying to beat the market.
3. Add an active manager to fine-tune the volatility of your portfolio.
This reason doesn’t make much sense since active managers actually just layer an additional level of risk on your portfolio. An investor already has to deal with the volatility of the markets. Why add the unknown human risk of an active manager to the equation?
4. Use a mix of funds to hedge against market crosscurrents.
Michael Ricca, managing director for Morgan Stanley, says, “Passive and active funds tend to perform better in different environments. It can be better to own an active manager who can scout for attractively valued securities or shift to sectors that might hold up better in a correction.”
I think the writers of this article are missing the point. Active managers have consistently underperformed their passive counterparts in 21 out of 22 asset classes over the last 5 years. There is no credible evidence that active managers can add value through security selection.
5. Use an active-passive blend to bring down overall expenses.
The article says that “Many active funds charge 1% or much more in annual expenses, while index funds may charge as little as 0.05%. Even if you generally favor active funds, you might use a blend to lower your overall portfolio expense ratio to perhaps around 0.5%”.
Alternatively, you could use index or low-cost passively managed funds in all investment asset classes to reduce the cost of your investment portfolio. Remember, the saying “you get what you pay for” does not hold true when it comes to investing.