For decades, a fierce debate has been raging in investing circles: Which is better, active or passive management? According to the active management crowd, a talented stock or bond picker can find a way to rise above the averages and deliver performance. During times of volatility like today’s coronavirus-inspired market swings, managers should be able to find better performing stocks or ones that might escape the widespread pounding.
Passive managers, on the other hand, believe that the pursuit of market-beating performance is futile because beating the market is hard. Many investors have tried—and failed—to gain an investing edge. Their aim is simply to mimic an index, whether it’s the Standard & Poor’s 500, the Nasdaq or the FTSE, without placing bets on which stock will rise and which will falter.
The indexers believe that for every early-stage Google a hot stock-picker might turn up, it’s just as likely they’ll end up with a pets.com, the early Internet phenom that crashed spectacularly.
“Most of the juice of stock market returns is in just a few names, but you run an equal risk of not capturing those names,” said Jim Rowley, senior investment strategist with indexing powerhouse Vanguard. “If you have a diversified portfolio, you are more likely to own the names that drive those returns.”
Lately, it looks like passive investing has the upper hand. In August 2019, the assets in U.S-based passively managed equity mutual funds and exchange-traded funds overlooked those in active funds for the first time, according to Morningstar Inc., the investment research firm. In 2020, passive equity funds commanded 51.2 percent of the market.
“This is the product of a ten-plus year bull market that really favors index funds,” says Charles Sizemore, chief investment officer of Sizemore Capital Management, noting that in the last bear market actively managed funds didn’t perform much better than their passive brethren. “Index funds are doing really well because more money is going into index funds, which means more money is going into the stocks of index funds. It’s a circular thing.”
Is it time to declare the era of passive management here? Yes, indeed, but don’t discount active management, just yet.
Index investing’s long road to prominence
When John Bogle created the first index funds at The Vanguard Group in 1975, retail investors lagged far behind investment pros. The mutual funds available to them were expensive and failed to keep pace with the performance that savvy investors generated. Bogle reasoned that most of an investor’s returns come simply by participating in the market, a concept known in investing as beta.
To get the most benefit out of an investment, investors needed to overcome the usual hurdles to performance, which Bogle identified as fees and taxes, so they could get more beta out of their investments. Bogle lowered those hurdles with index funds. Index funds were able to keep their fees low because they didn’t need to employ armies of research analysts and managers to monitor their holdings.
And by following an index, these funds only trade when a stock enters or falls out of the index. That keeps trading costs down and tax burden to a minimum. It took a while for Bogle’s idea to catch on, but it ended up revolutionizing investing by driving down investment costs throughout the industry.
“Investors can access so many strategies and regions of the world for just a fraction of the cost than it would have cost in the past,” says Ben Carlson, director of institutional asset management with Ritholtz Wealth Management.
Passive investing is available in mutual funds, the main investment vehicle in employer-sponsored retirement plans such as 401(k)s and 403(b)s. It’s also a mainstay of exchange-traded funds (ETFs) which really helped indexing take off. Unlike mutual funds, ETFs can only be bought and sold through a brokerage firm, but their fees are even lower. Discount brokers and the new crop of low-cost digital asset allocators have helped investors get access to passive strategies at ever lower price points.
“ETFs are everything that’s great about index mutual funds plus tax efficiency plus liquidity,” says Sizemore.
The evidence mounts
A big part of the appeal of indexing is the growing body of evidence of its performance—which is largely a function of its lower fees. It’s simple math: The less an investment charges, the lower the performance it needs to achieve to beat out more expensive alternatives.
In a recent paper, Vanguard looked at the gross performance of active and passive managers and found no difference. In other words, when all things were equal the two types of managers had similar performance results. But all things aren’t equal. Passive managers tend to charge less for their products, and they tend to have lower trading costs too. When those things are factored in, passive investments win. And since those factors are persistent, they impede performance during bull and bear markets. Vanguard found that in the financial crisis of 2007 and 2008, just 44 percent of active managers outperformed.
“Indexing works because of the zero-sum theory,” explains Rowley of Vanguard. “If there is an average return, then for every dollar that does better than the average, there’s a dollar that does worse. What the indexer says is, ‘I’m happy to take the market average and let all you active managers duke it out.’”
Indeed, according to the S&P Indices Versus Active Scorecard (SPIVA), a semi-annual report comparing actively managed funds to their benchmarks, just more than 12 percent of all actively managed funds outperformed in the last 15 years. The record is even worse in some asset classes like emerging markets, mid- and small-cap stock, and international markets, where less than 10 percent of managers pulled off the feat.
Yet during certain periods, active management holds its own. According to Morningstar, 44 percent of active funds beat the passive benchmark for their categories in 2019, with growth funds having the most success. Two thirds of those types of funds pulled off that feat.
Too much of a good thing?
For all of indexing’s positives, the style isn’t without its controversies.
First, there is the natural resentment from adherents of active management who believe it can go too far and distort the markets. One hyperbolic critique came in 2016 from the investment firm, Bernstein. Inigo Fraser-Jenkins, an analyst, wrote, “A supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market-led capital management,” essentially comparing indexing to Marxism.
Today, some in the investment community worry that too much money going into passive strategies artificially inflates stock prices and creates a bubble. With this current downturn, they argue, stock prices will take an even worse hit than they normally would have. That’s an argument that Carlson of Ritholtz likens to chastising someone for adopting too many healthy eating and exercise habits. And, Vanguard argues, on a global basis indexing is still a fraction of total investment dollars.
But that’s not to say that investors can’t get carried away with indexing. While index funds themselves are passive, investors tend to use them in active strategies. An investor might quickly swap out a natural resources fund if they believe that sector might falter and opt for say utilities or infrastructure that might offer better opportunities. The structure of ETFs, which trade like stocks through a brokerage, enables these rapid-fire trades. Those behaviors can undermine the benefits of indexing.
“The low cost and tax efficiency of indexing can be eaten away with bad trades,” notes Carlson.
A place for both
But even some dyed-in-the-wool indexers acknowledge that active strategies can have a place in an investor’s portfolio. Some investors use a “core and explore” or “core and satellite” strategy to get the best of both active and passive management.
Core and explore acknowledges that it’s hard to beat indexing for market exposure. Developed markets—where investors are advised to have the lion’s share of their assets—are so efficient that it’s hard to imagine an investing edge that active management could offer. For that, it’s best to just have market exposure at the lowest price possible through passive strategies.
Then for the possibility of outperformance, known as alpha, you might look at active managers with a proven track record of outperformance in their particular segment of the market. “There are smaller markets, and some geographies around the world where active management can add value,” says Roger Young, a senior financial planning at T. Rowe Price, a family of actively managed mutual funds.
But not all active managers are created equal. For active managers to be worthwhile, they must have low fees, have a proven track record, and have the resources to do investment analysis, Young says. Morningstar’s research bears this out. The cheapest active funds managed to outpace their benchmarks at about twice the rate as the priciest.
Sizemore, for one, believes that active managers have a place in his client’s portfolios if they offer true diversification. He seeks out actively managed funds that are uncorrelated with the market and have the ability to invest in completely different fare. He doesn’t use active strategies to eke out a point or two of outperformance. Instead, he uses active strategies for downside protection for his clients who are near or at retirement. For example, funds that can hedge or short securities have this potential and could be a ballast against widespread market losses.
“The older you are, the more specialized your needs will be, so pepper in an active strategy such as dividend-generating stocks,” he says. “Active management has value as a risk management, too.”
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.