Explaining the active-passive management debate

In the end, there’s no one-size-fits-all investment strategy

After almost eight years in a U.S. bull market, there seems to be an incessant drumbeat for passive investment strategies by both institutional and individual investors alike. The ongoing debate around active vs. passive management stems from the fact that, on average, the majority of active investment strategies have struggled to outperform their low-cost passive counterparts. Because of this, many active managers are struggling to justify their expense – and with future returns expected to moderate, this is an issue that remains directly in the crosshairs. 

It’s no question that the underlying expense for many active management funds is high. To justify the expense, some strategies mimic their respective benchmark with minor deviations that represent the “active” component of their strategy, while others may take the opposite approach and are benchmark-agnostic, only using an index to measure relative performance over full market cycles.

In addition, expenses are often layered, which has created the perception that these fee structures lack transparency and legitimacy. 

Even Warren Buffet has publicly stated that the best option for most investors is to invest their money in low-cost index funds and “forget about it.” The irony is that Mr. Buffet created his own personal wealth and value for his shareholders with active management and a long-term outlook, not passive or indexed investing. 

Not surprisingly, these factors have led to a massive expansion of passive strategies over the last eight years. In 2008, there were 1,591 exchange-traded funds worldwide; by the end of 2015 there were 4,396. So much money has flowed into passive strategies that Vanguard now has a 5 percent ownership stake in 468 companies in the S&P 500. That number was three back in 2005.

The popularity and near-term success of passive strategies is literally beginning to change market structures, and with this change comes significant new risks.

A purely passive investor following a benchmark such as the S&P 500 (which weighs companies based on their market capitalization) automatically owns more of what gets bigger and less of what gets smaller based solely on the size of each company, regardless of that company’s fundamentals (for example, whether the stock price is overvalued or undervalued). In short, index funds simply accept stock prices as they are, without concern about valuations or market distortions. This may cause significant impairment to the long-term investor, as valuations and relative valuations have a tremendous impact on long-term returns (buy low, sell high), and ignoring this risk could be detrimental to a portfolio. 

Passive strategies may also face their own issues surrounding corporate accountability and transparency. It is widely known that index funds traditionally approve most every initiative put forth by corporate boards and senior management, particularly surrounding the compensation of the company’s executives or dividend payments.

Unlike active funds, passive funds often do not utilize the equitable practice of shareholder proxies, the process by which shareholders can vote on board members and other corporate changes and can essentially abandon their responsibility as owners, investors and fiduciaries. One may argue this has the potential to perpetuate income inequality and further stifle corporate investment.

There is much lip service paid to the concept of “maximizing shareholder value,” but how often do the shareholders in passive index funds or even ETFs ask how their proxies are voted?

Lastly, too many industry “experts” are professing exclusive support of passive or active investing, with no room for compromise. Why must it be one or the other, and who is to say there isn’t a place for both types of strategies in a well-rounded portfolio?

What is often lost in the debate are the variables of active management that do tend to deliver outperformance and manage risk over time. There are three traits that can help identify actively managed funds with a track record of outpacing indexes over long periods:

• Active funds with lower expense ratios have tended to outpace their respective indices more frequently than more expensive peers.

• Investment firms whose managers invest more of their own money in their funds have tended to outperform. 

• Funds that tend to lose less than the market during significant declines have, on average, outpaced their peers, and in many cases, their respective indices over time.

Active funds that exhibit all three of these characteristics have tended to outpace both their peers and their benchmarks over all meaningful time periods, and with better risk-adjusted returns.

To us, this alignment of interests represents a valid and commonsensical approach that’s deserving of a seat at the table in any prudent and responsible investment approach.

Regardless of the challenges faced by active managers in recent years and the rising popularity of passive strategies, the fact remains that there is no one-size-fits-all investment strategy, because there are few hard and fast rules of investing. (If there were, we would all be rich!) A strategy that works well during one market cycle may not be the solution in the years ahead.

In the end, we need look no further than the tiny print below for the pointed truth: cheaper isn’t always better, and past
performance is no guarantee of future results. 

Tom Sedoric is managing director-investments of The Sedoric Group of Wells Fargo Advisors, Portsmouth. D. Casey Snyder is a financial consultant with the firm. They can be reached at 603-430-8000 or through thesedoricgroup.com.