A short while back, a very large active mutual fund management firm (one that has earned the respect they deserve) had declared the active-passive debate to be dead, and that “each approach can be valuable in an investor’s portfolio.”
Was that a white flag or merely an honest and open minded statement?
In that spirit, reasonable people understand that both passive and active strategies have merit, and each brings something different to the table. Passive vs. Active will never be a dead debate, and that’s a good thing. I hope the debate never ends because assertive argumentation and spirited competition breeds improvement.
The passive approach may be the appropriate way to go for most investors because the vast majority of active mutual fund managers do not beat their benchmarks. While a mathematical impossibility, it happens, but too few management teams have the collective skills to beat their benchmarks consistently, and the cost structure of mutual funds (loads and fees) eat deeply into performance, which becomes all the more evident and painful in down years.
Collective, pooled investments like passive exchange traded funds (ETF) don’t share those same drawbacks. An investor who wants to invest for the long term and simply “be the market,” year in, year out is likely to do better over the long run.
Consider fees. Active management fees don’t stand out as much when equity markets are pumping out big returns year after year. They disappear like vapor. But does a strong market alone justify the management fees in the first place? Fees relative to a particular fund in a bull run is one thing, but what about ALL other active funds, or ETFs with lower fees over the long haul? Is it good enough that investors don’t notice the high fees they are paying because of relative short term performance?
Consider alpha. Alpha is the extra return that a skilled manager will earn for you above the market due to their research and execution prowess. The questions there are many: Am I with a skilled manager? Is the manager producing alpha year after year after year? After fees and trading coats, would I have been better in a portfolio of passive ETFs? The most important question is this: Do you really want to take the excess risks required to possibly earn the excess returns?
Did you leave more than 10% on the table?
There is very often a great difference between investment performance and investor performance. Dalbar, Inc. is the nation’s leading financial services market research firm. Each year they update their annual Quantitative Analysis Of Investor Behavior study. Consider these sobering facts from the latest available Dalbar findings for the twelve months ending December 31, 2021: According to a Dalbar report, the average equity fund investor returned 18.39% compared to 28.71% returned by the S&P 500.
So active managers are recognizing the problem they created, as ETFs and other passive management solutions and strategies continue to steamroll ahead, gaining more and more followers. The result has been that the active management community has been forced to lower fees in order to compete with the ultra low fees of ETFs, and lower fees are always better for investors. And the response to lower fees is why the debate cannot die. The debate has bred positive change, but the active management industry has further to go in understanding investor behaviors.
Market volatility is alive and well in 2022, which may make active management more attractive. Yes, indeed, active strategies can be just the ticket in the short swing, but long term, many investors can’t stomach the volatility in active strategies, so passive investors may have the upper hand. Simple odds, the law of large numbers and a lower cost structure give the nod to the passive portfolio. Simply earning what the market gives, year in, year out, in both good markets and bad, rewards investors handsomely who stay invested for the long haul.
Oh, behave!
And what this active manager’s statement completely ignores is how investors behave in times of turmoil. Sure, you may have a great run going, but what do far too many investors do when there’s trouble? That’s right. They bail. Check the annual Dalbar studies on the difference between investment performance and investor performance. The gap is alarming.
They state that, “the pendulum has swung too far toward passive…,” which means that it has swung too far from active managers as more investors wake up to facts. The pendulum has indeed swung very far, for many positive reasons to go passive, but the swing over to passive marches forward to a very fast drumbeat, and the active managers are worried.
Today’s passive investors enjoy the opportunity to create customized and easy to manage portfolios with low cost, diversified exchange traded funds; portfolios that range from simple to complex, and may include everything from the most common of common stocks to very narrow sectors.
Passive portfolios will satisfy the risk and return objectives of any investor, providing proper diversification, low costs and high tax efficiency. Because of this, the passive investing community continues to grow, and unless the active management industry can begin to understand investor behaviors, they have reasons to be concerned.