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If you can't beat them . . . join them

Oct 15, 2020 | Thomas Smith


Which is better? I can tell you which is cheaper! But does the extra cost of active management give one a better return on your investment?

Thomas in front of a painting

I am reminded of a popular phrase:  “If you can’t beat them, join them.” If you are an NBA fan, you know Kevin Durant of the Brooklyn Nets.  He played 7 seasons with the Oklahoma City Thunder, before transitioning to the Golden State Warriors in 2016. He then proceeded to win 2 NBA championships in 2017 and 2018, and won the NBA Finals MVP both years. The Golden State Warriors were a powerhouse team even before the addition of Kevin Durant, and his presence solidified their position as the “favorite” to win the NBA title both years. 

This is also an apt quote to describe the popularity of index funds and the “passive” investment notion. Passive investing is most often associated with John Bogle, the legendary founder, and CEO of the Vanguard Group, who is commonly referred to as the inventor of the Index fund. No one knew that upon his founding of Vanguard in 1975, that Bogle would usher in a massive shift in investing and money management that would allow low-cost indexing to become mainstream to the point where Big Wall Street firms realize that “If we can’t beat them….join them!”

Most of the large Investment management firms now either have their own cadre of index-based funds or advocate for this approach. An Exchange-traded fund is similar to a mutual fund. They both own a basket of securities. Mutual funds are valued once a day, and trade at the market close, while exchange-traded funds are valued intraday, and can therefore be traded throughout the day.

I mentioned in a previous article that I would write about the ongoing debate between “Passive” investing, and “Active” management. With the recovery that we have seen from the March 2020 lows, now is a good time to unpack this debate. 

First some definitions:  

  • Passive investing involves owning defined groups of stocks or bonds, often called “indexes”.  While one can not invest directly in an index, an investor can purchase a Mutual Fund or an Exchange Traded Fund that inexpensively tracks that index.
  • Active management involves building a portfolio of individual stocks or bonds by name,  either by yourself or with the help of a portfolio manager. 

The most common example of an index is the S&P 500. It is a defined group of the 500 largest US stocks. The Russell 1000 index is a defined group of the largest 1000 US stocks. The Russell 2000 index is a defined group of the largest “small” public companies in the US. Each of these three aforementioned groups is defined as an “Index”.  There is an index for virtually every, style, size, country, and type of stock and bond investment.  

If you are an investor who builds your portfolio using these indexed baskets, you are an “Index” investor.  The primary benefit of the “Passive” or “Index” strategy is the low-cost nature of these investments.  The internal cost of these funds is very low. The biggest players in this space include Vanguard, Blackrock, Invesco, State Street, and Powershares. Investors who employ the Index or Passive approach believe that money managers, and the fees they charge, cannot outperform these inexpensive, passive indexed baskets over long term investment cycles. Essentially, a passive investor is willing to accept what the market delivers, with no attempt to outperform.  So goes the market…so goes her portfolio.  

An “active” investor, picks individual stocks (or bonds), with an attempt to select a superior composition of holdings and outperform an appropriate index. If the investor hires a third-party strategist to make the investment selections, these fees range from 1-2%. Alternatively, the investor could purchase a mutual fund, which is a pooled fund of stocks (or bonds) managed by a pedigreed professional which carry an annual fee generally ranging from .5 to 2%. 

As you can see, the Active investor is hiring a professional at an annual cost of let’s say 1.5% to attempt to outperform the market, while the passive indexer is simply owning the market at little cost. 

Which is better? I can tell you which is cheaper!  But does the extra cost of active management give one a better return on your investment?

The evidence seems clear: “The drumbeat of bad news for actively-managed asset management keeps getting stronger,” writes Andrea Riquier of Market Watch in September 2019. She writes: “Morningstar releases a semiannual analysis of active funds compared to passively-managed peers. The picture is not pretty for anyone trying to beat the market, especially when combined with the additional challenges of picking the right active manager and paying their fees. Only 23% of all active funds topped the average of their passive rivals over the 10-year period ended June 2019. What’s more, the cheapest funds succeeded more than twice as often as the priciest ones (33% success rate versus 14% success rate) over those 10 years.” 1

That being the case, many investors feel that 2020 created an environment whereby an “active” approach has a better opportunity of outperforming the average passive portfolio.  This is because there are a handful of stocks in 2020 that are largely driving the recovery from the March lows.

In an article published by the Washington Post on Aug 20, 2020 written by David J. Lynch, he writes:  “Five hundred companies make up Wall Street’s most widely used measure of the stock market’s performance: the Standard & Poor’s 500 index (S&P 500). If it were not for just six of them, the benchmark would be down this year.” These six stocks include some of the largest technology stocks in the world.

He notes: “Through Tuesday, (Aug 18, 2020), these six stocks collectively were up more than 43 percent this year, while the rest of the companies in the index together lost about 4 percent.”2

This means that a passive investor who purchased the S&P 500 index has been rewarded with a relatively flat performance in 2020, while an active manager, who owned the six stocks mentioned above, could achieve superior returns by active stock selection.  

The ongoing debate between “Active versus Passive” will continue, and markets will rise and fall.  But one thing is certain:   There is a subset of affluent investors who want and need to rely upon a professional to help them navigate the complexities of investing during uncertain times; to help them create a portfolio that can sustain the burden of withdrawals during retirement without the risk of outliving their assets. For those investors…my team will be here. Give us a call, let us walk the road with you.