Winston Churchill is often credited with the statement that democracy is the worst form of government, except for all the others that have been tried.
This is a lot like how I view the whole active vs passive management debate because there is no perfect way in which to manage a portfolio. But I believe there are significant guideposts to follow that can make the decision a little clearer. There has been a lot of ink spilled over this single issue, especially within the industry. But I wanted to share my thoughts on the topic specifically detailing my thought process and the #1 reason that I passionately believe in passive investing.
This is a bit of a long article, but I’d encourage you to stick with me. Most people wouldn’t think twice about spending two hours researching a new refrigerator, but don’t want to spend 20 minutes researching a portfolio strategy that could impact their future for decades, not to mention be worth potentially thousands of dollars. Let this be the 20 minutes you spend to establish what is hopefully a lifelong strategy. My goal is to provide all the information I believe you need to make this decision for yourself. It will either encourage you to double down on your existing strategy or provide enough information to make a new portfolio decision.
What makes my experience interesting is that I started investing as a significant proponent of active management. So, as you’ll see, this has been a bit of an evolution of perspectives. I utilized both actively managed funds as well as picked my own stocks in my personal portfolio. I read books on Graham, Buffett, Lynch, Carlisle, Greenblatt, and many others. I even considered becoming a fund manager at one point. But, regardless of how serious I took the topic at hand, I was left underwhelmed and disappointed with the results.
I should note that my evolution from active management participant to passive management disciple is not a unique phenomenon. I know a whole host of advisors and clients alike that began believing in active management, thinking that they are going to be the next Warren Buffett, only to realize after painstaking effort that indexing, when it comes to establishing a lifetime portfolio, made more sense as a long-term strategy. And this appears to be a virtual one-way street since to the best of my knowledge, I am unaware of anyone that has gone from being a proponent of passive management to a disciple of active management. I’m not saying it hasn’t ever happened, I just don’t know anyone that has gone the other direction.
Given my experience and my profession, I was seeking an investment philosophy that I could believe in wholeheartedly without reservation for my clients as I have a sincere duty to help clients make the best choice possible when it comes to all topics of financial planning. And as far as investing goes, the passive management investing philosophy is what I feel will best serve my clients over the coming decades as I continue to build my practice.
What you’ll find below is my honest and detailed view of that discovery process. What I profess below doesn’t necessarily mean it’s right for everyone. But this is a foundational principle that I use for my own portfolio and most importantly for my clients.
I obviously believe this article works best in the order that it is laid out since the arguments build on each other, but if you are short on time, you will find the #1 reason that I advocate for passive investing toward the bottom of this article.
Active Vs Passive Management Briefly Defined
At the most basic level, active investing involves you or an outside advisor (typically a fund manager) picking stocks. This can be done within the package of a mutual fund, ETF or a basic trading account in which you may choose individual stocks. The latter option could be a DIY investor or a financial advisor choosing on your behalf.
Passive investing is, in general, a belief that the markets are efficient and therefore do not advocate for picking stocks. This is most often, though not always associated with the approach known as indexing. There is a bit more nuance to it than that, but for sake of this article, just know that passive investing does not involve any fund manager whatsoever specifically choosing stocks or bonds to invest in. Passive investing can be accomplished within the package of a mutual fund or ETF.
With that out of the way, the question I’m addressing today is why I personally believe passive investing best serves most investors planning for their future.
The Case for Passive Management:
The Performance is Equal Before Fees
This is a topic that I don’t believe gets nearly enough press in this conversation. The cumulative performance of active strategies is equal to the performance of passive strategies BEFORE fees. How is this possible you might ask? It works this way because the investment world is a closed system. For every single buyer in the market, there must also be a seller and vice versa.
To further clarify the closed system aspect of the stock market, John Bogle, the founder of The Vanguard Group (the second largest investment company by assets under management), states in his book “Common Sense on Mutual Funds“:
1. All investors own the entire stock market, so both active investors (as a group) and passive investors — holding all stocks at all times — must match the gross return of the stock market.
2. The management fees and transaction costs incurred by active investors in the aggregate are substantially higher than those incurred by passive investors.
3. Therefore, because active and passive investments must, by definition, earn equal gross returns, passive investors must earn the higher net return.
If there was ever an elementary, self-evident certainty in a financial world permeated by uncertainties, surely this is it.
It seems crazy to think that the cumulative result (before fees) of all active strategies is simply equal to the market movement as a whole. However, it only seems crazy though because of the industry-wide obsession with performance. That said, by virtue of math alone, whether by luck or by skill, there will be individual active managers who will outperform over any given time period. But as you’ll see below, only a minority of active investors accomplish this feat, and it’s incredibly difficult, if not impossible, to know who these managers will be in advance. Let’s take a look at the data.
The Data is Too Compelling to Ignore
One question you should ask yourself when developing your investing philosophy is simply, “Does the evidence support my position?” Given that single question, the evidence to me is pretty clear that passive management should be favored over active management. To this point, according to SPIVA, over the 15-year investment horizon ending in December 2017, 92.33% of large-cap managers, 94.81% of mid-cap managers, and 95.73% of small-cap managers underperformed on a relative basis to their benchmarks.
Perhaps even more compelling, an article published by the Wharton School (link here) shows that the after-tax results are even more concerning:
On an after-tax basis, after a recent 10-year period, managers of stock funds for large- and mid-sized companies produced lower returns than their index-style competitors 97% of the time, while managers of small-cap stocks trailed 77% of the time.
Therefore, at a practical level, the idea of active management outperformance appears to be statistically unlikely. And on a logical level, many investors that own one actively managed fund likely own multiple actively managed funds. Given the statistical headwind that these investors face with each individual fund choice, it would be statistically even less likely to build a portfolio of actively managed funds that beat a similarly allocated passive portfolio.
Let’s face it; if the primary selling point of active management is outperformance, and the above outcome is the result, I’ll let you be the judge of whether it’s a successful outcome.
Despite the data, a statement I hear regularly from the active management crowd is, “Surely your clients deserve better than the market’s average return.” If the data showed that there was a way to consistently do better, I could see the merit, but that just doesn’t appear to be the case from what I can see.
Therefore, I refuse to advocate for an investing process that appears to have such a statistically unlikely outcome regardless of how great the sizzle is. It just doesn’t make sense in my opinion.
That said, the results beg the question, why is the performance of most active managers so lackluster?
Plainly Stated, Active Management Is Hard
The data and performance issues noted above are not for lack of trying. Warren Buffett (ironically, given the topic of this article, widely considered the greatest active investor of all time) has a philosophy of ignoring items that cross his desk that he deems are “Too Hard”. His belief is knowing your circle of competence and staying within that circle. I am a believer in the idea that active investing as a whole should be considered “Too Hard”. Let me explain.
The sheer difficulty in picking the right stocks is a bet against virtually every manager. According to a whitepaper written by J.B. Heaton, Nick Polson and Jan Witte titled “Why Indexing Works”, active management may be even more challenging than previously believed. Here is a link to their study. Here is an excerpt from their paper:
On the empirical side, it is worth noting just how astonishing the wealth generation of indexing with only a very small proportion of winners has been for investors. For example, Bessembinder (2017) analyses the 26,000 stocks that have entered the CRSP database from 1926 until 2015. He finds that 58% of common stocks have underperformed the T-bill rate over their full lifetime. Moreover, the entire gain in the U.S. stock-market since 1926 is attributable to only 4% of the stocks. The top 86 stocks have created a 50% lion-share of the total $32 trillion dollars achieved. These effects do not seem to be disappearing; for example, Figure 2 shows a similar effect for the period 1989-2015. For example, the skewness in individual stock winners such as Amazon which has returned 35,000% from 1999 versus 181% for the S&P500 index is dramatic. Again, as in the full sample, more than 50% of the stocks in this period have underperformed cash.
I want to reiterate two points.
- The top 86 stocks (out of 26,000) have created a 50% lion-share of the total $32 trillion dollars achieved.
- “…58% of common stocks have underperformed the T-bill rate over their full lifetime.”
So, in practice, picking the “right” stocks is just unbelievably difficult. Lastly, on this topic, Warren Buffett himself advocates the use of passive management for the average investor. Mr. Buffett is quoted in “Common Sense on Mutual Funds” as saying:
“An investor who does not understand the economics of specific companies but wishes to be a long-term owner of American industry,” he says, should “periodically invest in an index fund.” In this way, “the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”
But what about those the active managers that have managed to “beat the market”? Surely, we could just look at the data to find the best managers, right?
For Those That Have Managed To Outperform, Past Performance Is No Guarantee Of Future Results
On every fact sheet or prospectus, you see the disclaimer, “Past performance is no guarantee of future results.” It is important to note, that this is a statement of fact. There is no empirical evidence whatsoever that a fund that has outperformed in one period will do so again in the future. Period. Hard stop. Unfortunately, because this disclaimer appears on literally everything in the investment industry, I believe virtually all the impact this statement once had has been beaten out of it and investors continue to flock to funds based on past results. After all, who wants to take a leap of faith on a manager who has previously underperformed?
There are many great studies on this topic, many of which can be found in an article by Larry Swedroe titled, “Chasing Active Outperformance Ratings.” In it, he closes with a great analogy regarding the reliability of past performance as an indicator of future performance and the ever-popular Morningstar ratings:
Philips and Kinniry concluded: “Higher ratings in no way ensured that an investor would increase his or her odds of outperforming a style benchmark in subsequent years.”
In fact, they found that “5-star funds showed the lowest probability of maintaining their rating, confirming that sustainable outperformance is difficult. This means that investors who focus on investing only in highly rated funds may find themselves continuously buying and selling funds as ratings change. Such turnover could lead to higher costs and lower returns as investors are continuously chasing yesterday’s winner.”
The bottom line is that using Morningstar ratings to identify future outperformers is like driving forward while looking through the rearview mirror; their ratings system does a great job of “predicting” the past.
But let’s say that regardless of the above information, we still want to give outperformance a chance, the question should naturally become, “How can we identify managers that will beat the market over the next 10-30 years?” (That’s obviously rhetorical.) At the end of the day, there is simply no way to know in advance which actively managed funds will manage to beat the benchmark. Just because a fund has beaten the index in previous years does not mean they will do it again.
Making Matters Worse, Active Funds Are Hard To Own
On the surface, this sounds odd but stay with me because when you think about this logically, this single issue may be more impactful than the rest of these combined. I’ll argue that passive management is a way to reduce the potential for harmful investor (and advisor) behavior.
Let’s assume that you own a diversified portfolio of actively managed funds. What do you do when a portion of these funds are going through a period of underperformance? Will you sell? Or will you stick with it because you believe manager X is going to do better in the future? If you stay, how do you know the manager will eventually turn it around? Or when they’ll turn it around? How long do you give this respective manager to right the ship? Six months? One year? Three years?
If you decide to sell, do you invest the proceeds with a 5-star fund manager? Or how do you decide the next fund to purchase? It’s only natural to look at their recent previous returns to evaluate the viability of this new manager. We just saw above what typically happens to 5-star funds. What if you select that manager just as he/she is at their cycle peak and about to hit the down-cycle? Then what? It could get worse, because what if you decide to stick it out with various managers regardless of recent performance? What if their performance issue isn’t just a recent performance issue and the manager has lost their edge? Then what? Perhaps you could tell me because I can’t see where an investor might get off this merry-go-round of fund selection decisions based on fund performance or a variety of other factors.
As an emotional investor, which is a redundant term, it is only natural to review our portfolio holdings and focus on the underperformers. This may be the greatest risk associated with active management. Passive management has the potential to reduce the emotional sine wave associated with your individual portfolio holdings and managers. With passive management, the only decision to make is what asset allocation you should own relative to your goals, (rather than which managers you want to hitch your wagon) because there are no manager cycles to worry about. I want clients to own investments that they can hold for decades and in my opinion, passive management makes that process a little easier.
Passive Funds are Generally Less Expensive
According to the 2017 Investment Company Fact Book by the Investment Company Institute, the average actively managed equity mutual fund has an expense ratio of approximately 0.82%. As investors have become more fee conscious, the industry has taken note. According to the same site, Since 1996, the average expense ratio has dropped from 1.08% down to the 0.82% noted above in 2016, so it’s trending in the right direction. One can only hope this trend continues.
But when compared to the average index fund, in 1996, the average index mutual fund charged 0.27% and has gone down to 0.09% in 2016. Significantly less.
The difference in the fees to own these two respective assets (approximately 0.73% difference) must be overcome dollar for dollar in performance if the actively managed fund is to beat the relative benchmark.
Taking this issue a bit further, according to a whitepaper written by Russell Kinnel, he finds a direct negative correlation between fund cost and fund performance. To summarize his historical findings, the higher the fund cost, the worse the relative performance of the fund. Here is a link to that Morningstar study. That being said, if you decide you’d still prefer to own actively managed funds, then it would be worth considering funds with a lower cost of ownership.
Passive Funds are Generally More Tax Efficient
When it comes to taxable accounts, the tax efficiency of the fund can make a big difference in the after-tax performance of your portfolio. Due to management decisions, actively managed funds can have significant turnover within their portfolio. Portfolio turnover is defined as how often the fund replaces all the holdings in their fund. For example, a fund with 100% turnover would have an average holding period of less than one year.
As for how this impacts your taxes, if a fund has an average turnover of 25% per year, this means that on average the fund will turn over 100% every four years. There are two costs associated with this turnover, transaction costs, and taxes. Transaction costs are those costs that it takes to buy and sell securities which are passed on to you as the investor. This cost is hidden but is nonetheless real. But an even larger cost is the potential tax associated with this turnover. When managers sell positions with capital gains, this tax liability is passed on to you.
For example, if a fund returned 8% according to their fact sheet, but they are recognizing capital gains of 8% on average due to the fund’s turnover, then each year your net return could be reduced by up to 1.84%.
For more on these two costs and various other costs, click here. Investors should seek to minimize all of these costs and performance drags as much as possible. Disclaimer: As federal and state tax rules are subject to frequent changes, you should consult with a qualified tax advisor prior to making any investment decision.
Final Perspective on the Data Above:
Given all the information above, I am not saying active managers can’t outperform. I know for a fact that they can as it’s been accomplished countless times. The problem is that I don’t know in advance who those managers are going to be (nor does anyone else). And considering the statistical likelihood over entire market cycles, that is not a risk I believe investors should take in their portfolios.
All that said…
The #1 Reason I Advocate for Passive Management for Clients:
While all the information above is compelling, I believe that active management is entirely unnecessary for goals-based planning. When I meet with prospective clients to discuss their goals, I have never once heard that they would like their portfolio to beat some benchmark index. They are interested in meeting their goals, period. Thus, the primary goal of building a lifelong portfolio is and should be to reach your goals, not to compete for returns.
My job, as I see it, is to do all I can to help clients eliminate or at least mitigate the known possible frictions that could potentially reduce the likelihood of achieving their goals. And I believe that active management would fall into that category. By attempting to beat the market, you are by default introducing the possibility of underperforming the market. The side effects of active management are also uncontrollable such as the taxes due to fund turnover, transaction costs, style drift, and so on.
I think clients are better served focusing on items in which we can make measurable progress and actually control such as proper retirement planning, estate planning, making better overall distribution decisions, understanding the risks associated with specific courses of action, and so on. Educating yourself on all aspects of financial planning rather than trying to beat the market can have a true measurable effect.
I’m of the belief that all investors should be goals-focused rather than focused on ‘beating the market’. Outperformance is not a cure-all for bad planning. If you feel you are off track, then perhaps it’s time to revisit your goals and how you’re funding those goals, rather than trying to identify the next hot manager.
The portfolio is, in reality, nothing but a tool to help you to achieve your goals. Market-based returns from passive management should be sufficient to reach your goals given enough time and resources allocated to your portfolio. Therefore, I believe attempting to identify a portfolio or manager that can “beat the market” is simply an unprofitable distraction from the real issues that can make a significant difference in your financial life and in any case is wholly unnecessary for goals-based planning.
Closing:
There is a great book called, “How to Lie with Statistics” written by Darrell Huff. In it, he basically discusses all the various ways that we can make statistics work in our favor to “prove” that we are correct. It’s common in politics, investing and virtually every other field. We naturally seek confirmation bias in all that we do. So, I am aware that the studies noted may have bias to support my points though many are from disinterested parties. Additionally, I am an independent advisor and am not limited to any type of investment, so I am unbiased in that regard as well. Passive investing just seems to be the common sense approach to me.
But my hope to you, dear reader, is that you can see that my argument for passive investing is more about what the data shows and controlling what you can control. If you decide that you’d like to do more research on your own, you can do a quick Google search of active vs. passive investing and you’ll have more than a few weekends worth of reading to help you draw your own conclusion. With that said, I hope that this article adds some clarity to the on-going debate and offers food for thought as to what you may consider doing with your own portfolio.
If this strategy appeals to you and you’d like to chat about your goals, please feel free to reach out to me at “daniels at shorebridgewm dot com”. And if you found this content valuable, consider signing up to receive these posts as I publish them. I promise not to clutter your inbox as I will likely post just once per week at the most.
Thanks for your interest in my work!
-Ashby Daniels
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This material is being provided for information purposes only, should not be construed as a recommendation, and is not a complete description necessary for making an investment decision. Opinions are those of Ashby Daniels and not necessarily those of Raymond James or RJFS. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Past performance is not indicative of future results. There is no assurance that these trends will continue or that forecasts mentioned will occur. The S&P 500 is an unmanaged index of 500 widely held stocks. Keep in mind that indexes are unmanaged and individuals cannot invest directly in any index. Index performance does not include transaction costs or other fees, which will affect the actual investment performance. Individual investor results will vary. Companies engaged in business related to a specific sector are subject to fierce competition and their products and services may be subject to rapid obsolescence. There are additional risks associated with investing in an individual sector, including limited diversification. Investing in small-cap stocks generally involves greater risks, and therefore, may not be appropriate for every investor. Stocks of smaller or newer or mid-sized companies may be more likely to realize substantial growth as well as suffer more significant losses than larger or more established issuers. Though it can help mitigate risk in a portfolio, asset allocation does not ensure a profit or protect against loss. Investing always involves risk. No investment strategy can guarantee success. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Raymond James is not affiliated with and does not endorse the opinions or services of independent third parties named herein. Links are being provided for informational purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor any of the listed web sites or their respective sponsors. Raymond James is not responsible for the content of any web site or the collection or use of information regarding any web site’s users and/or members.
