Among participants in the investment community, there have long been debates on whether the active or passive style of investing provides the better outcomes. Not unlike politics today, there are strong opinions on which is better, and each side often completely dismisses the other. We believe the optimal solution lies somewhere in the middle.
Active managers select securities using a combination of fundamental and quantitative research. Passive managers will quite simply buy stocks in an entire index (the most popular is the S&P 500) in an effort to match its performance. There are benefits and drawbacks to each style of investing. When considering these pros and cons, we study mutual fund research databases which provide historical performance and risk measures on over ten thousand mutual funds, including actively-managed funds and passively-managed funds (index mutual funds and/or exchange-traded funds).
The most well-known benefit of passive investing is its low cost relative to active management. The other main advantage passive investing has over active investing is its tax efficiency, which is a result of the low turnover resulting from a buy-and-hold strategy.
The main drawback to passive investing is the lack of flexibility the manager has to make changes to the index. Passive investors may be forced to own securities that are in a struggling industry, just had a major scandal or are in an industry that offends them morally. Additionally, they have to accept the weight of each company or sector in the index. The energy sector was over 30% of the S&P 500 in the 1970s; today, it is only 6%.1 The financial services sector contributed to the underperformance of passive managers during the financial crisis, as they were required to own bank stocks as they continued to drop and the banks in some cases went out of business.
A major benefit to active management is the ability to adjust the level of risk relative to an index. Managers can overweight or underweight certain sectors or securities. In addition to the instances mentioned above, active managers can also choose to be more defensive by holding additional cash if they do not see good investment opportunities. They could also shift to a more defensive security within the same sector. For instance, Tiffany and Co. and Target Corp. are both in the consumer discretionary sector. Tiffany’s stock would likely be more affected by a slowing economy than Target’s stock. The S&P 500 Index would have to own both. The active manager could choose how much, if any, of each stock to hold.
While the ability to hold additional cash can be a benefit to active managers, it is more often a drawback. Passive managers are usually fully invested into the index they are tracking. Active managers usually keep more cash on hand, either to be opportunistic based on their view of the market, or just to meet investor redemption requests without having to sell securities at a taxable gain. This “cash drag,” along with higher expenses, are the major detriments of active investing.
The answer really depends on what time period you are reviewing. For this study, we will concentrate on the Large Cap Blend category in Morningstar. This is the largest Morningstar category (16% of the US mutual fund market) and large cap is widely considered the most efficient asset class, and therefore the asset class in which passive investing supposedly would make the most sense. Recent history has certainly favored passive management, as passive funds have outperformed their active counterparts seven out of the last eight years. However, in the so-called “Lost Decade” of 2000-2009 when the market suffered two major bear markets (resulting from the technology bubble and financial crisis), active funds outperformed their counterparts in nine of those ten years. Going back even further, passive funds/managers outperformed in 1994-1999 during the tech boom.2 In the late 1990s, indexes became heavily weighted in tech stocks (most indexes are weighted based on market capitalization), and the large stocks ran up so much they ended up dominating the S&P 500 Index. When the tech bubble finally burst in 2000, the top five stocks in market cap were responsible for over one-third of the loss in the S&P 500.1 Are we starting to see a repeat of that with the recent performance of the FANG (Facebook, Apple, Netflix and Google) stocks?
With the benefit of hindsight, the recent outperformance of index or passive funds is not that surprising, and would explain why the market share of passive investing has more than doubled in the past decade. At nine years and counting, we are currently experiencing the longest bull market run in history. Passive investing will usually benefit in this type of environment, as being fully invested is more important than fundamental research, earnings quality and risk controls. However, we do not believe we are finished seeing bear markets or corrections.
The S&P 500 fell 7% in October. We are not sure if that is a brief pullback on the way to record highs or if it’s just the beginning of the first bear market (defined as a 20% drop) this decade. There have been 23 market corrections (defined as a 10% drop) in the last 30 years. Active managers have outperformed passive managers in 18 of those 23 market corrections.3 Despite the strong recent run by passive managers, we do not think active management should be abandoned, considering August 22, 2018, marked the longest bull market in history.
At Bragg, we believe the markets are efficient; market prices for stocks accurately reflect most publicly available information about underlying companies. We believe methods such as sector rotating, picking “next year’s winners,” market timing and frequent trading will be detrimental to risk-adjusted returns in the long term. Therefore, we strive to build a well-diversified, low-cost portfolio that is invested with an appropriate level of risk given an investor’s age, need for liquidity or growth and tolerance for risk. We prefer to create our large cap portfolios using approximately 60 individual stocks. The portfolio includes exposure to all sectors of the US economy and generally owns many of the larger companies in each sector. The portfolio has very low turnover (infrequent trading). In this way, the large cap portfolio is passively managed. There are no underlying expense ratios with individual stocks, so the cost is lower than the cost of most index funds. Additionally, owning individual stocks is more tax efficient than owning a mutual fund. For example, if a specific account requires regular withdrawals, we are able to select specific securities for liquidation, potentially allowing us to sell securities with less embedded gain, or even securities with a loss, creating less of a tax burden than we would create if we were forced to sell shares of a mutual fund. Another tax advantage to owning individual stocks is the ability to gift a highly-appreciated stock position to charity instead of cash.
We do focus on risk when building portfolios. We study valuations when choosing individual large cap stocks and usually avoid companies if we don’t believe the financial statements justify the current stock price. We also tweak sector weights to overweight sectors we feel are undervalued or underweight sectors we feel are overvalued. This is active manager behavior. We seek to combine the benefits of active management (risk management, downside protection, customized portfolios) with the benefits of passive management (low cost and tax efficiency).
Rounding out the Bragg portfolio, we’ll gain exposure to asset classes other than large cap stocks such as small cap, mid cap, foreign stocks and fixed income by using low-cost mutual funds, index funds or exchange-traded funds (ETFs). Some of the mutual funds that we own are not tax efficient but in most cases we are able to own these funds in our clients’ tax-deferred accounts (IRAs, Roth IRAs) where unexpected capital gain distributions are not taxable, thereby enjoying the diversification these funds provide but avoiding the associated tax bill. We call this “asset location,” discussed in Asset Location for Tax Efficiency: What You Need to Know.
The Capital Group performed a study from 1996 to 2016 looking at the percentage of time large cap funds outperformed the S&P 500 Index over monthly rolling ten-year periods. The average fund only outperformed 24% of the time. Pretty lousy, huh? However, funds that scored in the top quintile for both low fees and high ownership by the managers (eating your own cooking) outperformed 89% of the time. At Bragg, we focus heavily on keeping the cost of the underlying portfolio down. Our aforementioned underlying portfolio that uses individual stocks for the large cap portion of the portfolio and low cost mutual funds or exchange-traded funds for other asset classes typically costs 20-25 basis points, or 0.20-0.25% per year. For purposes of comparison, the asset-weighted expense ratio of the average active mutual fund was 0.72% while the average passive mutual fund expense ratio is 0.15%.4 As for eating our own cooking, be assured that the accounts of Bragg employees are invested just as described here.
In summary, we believe a diversified portfolio that emphasizes low cost, tax efficiency and risk management provides the greatest probability of investment success in the long term.
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.