The Fix The Investments Series

A very large active mutual fund management firm (and to be fair, one that has earned the respect they deserve) has declared the active-passive debate to be dead, and that “each approach can be valuable in an investor’s portfolio.”

 Okay, we appreciate the white flag and the open minded statement, and in accordance with that same spirit, we agree that each approach can be valuable and there may be room for each approach in many portfolios. But calling the debate dead is premature. It’s a good debate. It should last, because assertive argumentation and spirited competition breeds improvement. 

The passive approach is the appropriate way to go for most investors because the vast majority of active mutual fund managers do not beat their benchmarks. It happens, from time to time, 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.

ETFs don’t share those same drawbacks

The same very large active mutual fund management firm correctly points out that “fees don’t stand out as much when equity markets are churning out big returns year after year.” Of course, but does a strong market alone justify the 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?

They do go on to say that “…a beta wave featuring double-digit annual returns can keep the spotlight off advisory and active-management fees—even if active managers are underperforming…how can you be sure an active manager can deliver alpha that justifies what it is charging?”

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 2016: In 2016, The 20-year annualized S&P return (1996-2016) was 7.68%, but the 20-year annualized return for the average stock fund investor was 4.79%.

Are you leaving almost 3% a year on the table?

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.

Market volatility is alive and well in 2018, which may make active management more attractive. Yes, indeed, active strategies can be just wonderful in the short swing, but long term, the passivists 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.

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. 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 it 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 sector plays as narrow as marijuana and cryptocurrency. 

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 the active management industrial complex continues to be concerned.

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