Published in Institutional Investor on September 9, 2018
Once upon a time, allocators in public markets chose between passive and active management. You could buy broad-based, cap-weighted, passive exposure to U.S. equities (the S&P 500 index), global equities (MSCI ACWI), or bonds (Lehman Aggregate) at a low cost, or you could pick among active managers at a higher cost, offering a range of strategies, styles, and sub-components of the market. Passive management and index funds were interchangeable expressions of the same concept. Fifteen years ago, that simple dynamic came to an abrupt halt.
That’s when investment providers created an array of ETFs that fell in between the traditional roles of active and passive. In addition to funds with broad market exposure, ETFs tracked single countries, sectors, styles, factors, themes, and even investor behavior.
Most ETFs have a rule-based process, which carries the label of an index. On a recent episode of my Capital Allocators podcast, Tom Lydon, the founder of news and information website ETF Trends, stated that 90 per cent of the $5 trillion ETF marketplace is managed by index funds.
The seemingly infinite supply of index products in the public markets throws a wrench in the active vs. passive debate. In 2007 I initiated a losing bet with Warren Buffet on the subject that pitted the returns of a portfolio of five hedge fund of funds against the return of Vanguard’s S&P 500 index fund. The variety of index options created over the subsequent decade made me think twice when looking back at Warren’s index selection. The S&P 500, comprised of large-cap, U.S. listed companies, has outperformed almost every other index over the last decade.
Does that mean that passive investing is the right way to go, or does it mean that large-cap, U.S. stocks had a great run?
Charley Ellis, founder of Greenwich Associates and author of The Index Revolution: Why Investors Should Join It Now, recently joined me on Capital Allocators, where he laid out a compelling narrative that the game has changed for active managers compared to when he started in the business in the 1960s.
The number of Chartered Financial Analysts has grown from a few hundred to a few hundred thousand. Information that once was scarce and slow to reach the market is now ubiquitous and disseminates instantaneously. Trading volumes shifted from 90 per cent mom-and-pop investors and only 10 per cent institutional investors to less than 1 per cent naïve players and over 99 per cent computers and institutions. It all adds up to a daunting task for a high-priced active manager to “beat the market.”
At the end of our conversation, Charley offered a prize to anyone who could provide a compelling, evidence-based argument that supports the benefit of active management for most people. I received a few responses, but no compelling ones arose. So he and I discussed the issue ourselves.
Our divergent opinion centered around semantics and implementation. We agreed on the importance of low-cost investing, but struggled to find common ground from there.
Charley believes in keeping investing simple, allowing the many intelligent competitors and their computers to do the work of price discovery. I countered that today’s index fund is not your mother’s passive investment strategy; too many options create a paradox of choice in which index selection is no longer a trivial exercise.
Charley eschewed the phrase “passive management” as nomenclature that turns investors away. After all, would your spouse want a passive partner in life?
He prefers “investing in indexes”, but I contended that anything less than active selection of an index is problematic in an increasingly confusing investment landscape. Is the S&P 500 equivalent to “the market,” or is owning an S&P 500 index fund an active decision to favor large, U.S. companies over a broader, globally diversified portfolio in a geographically interconnected world?
Long-cited academic research supports the outperformance of factors, namely value, momentum, yield, size, and quality, each of which can be indexed at a low cost with the potential to outperform the S&P 500 over time. Value and size in the U.S. have underperformed over the last ten to 15 years, so does that definitively determine that passively owning the S&P is better, or might it be true that the medium-term environment cyclically penalized these long-standing winning factors?
Arguments in favor of passive management grow specious when considering investments outside of large-cap U.S. stocks. For example, emerging market indexes are dominated by only a few companies and often are not representative of the economic opportunity set. Additionally, investors wanting to eschew traditional asset classes in favor of themes can identify indexes to express their views, but that practice is far more active than passive.
Perhaps the strongest argument against passive management comes down to price. The passive 60/40 stock-bond strategy has been a high-performing winner for a decade but may not be priced to produce returns that meet spending needs in the next decade. Most allocators and strategists are skeptical. Heck, in its recent mid-year review, even Vanguard suggested that passive exposures won’t deliver returns like they have in the recent past. The need for active management going forward seems more important than ever.
Any investor should be focused on achieving desired outcomes at a low cost, but conflating low cost with passive management is as out-of-date as paying an eighth spread and 25 cents a share to trade stocks. Investors need to make active choices, even when playing only in a universe of low-cost index funds.
Once upon a time investing was simple. Those trying to free-ride passively by owning the S&P 500 and play yesterday’s game plan might be in for a rude awakening in a different market environment than the one we’ve experienced of late.
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