Passive vs. Active

By Twickenham Advisors on May 19, 2017

Active fund managers are often nothing more than high-priced closet indexers. – Bill Miller

The top minds in the investing industry and academia have long grappled in an epic, Highlander-esque battle, arguing about the best approach to the very complex and broad topic of active and passive investing. In the past few years, it has been extremely difficult for many active managers to outperform passive counterparts in the same asset class. This is why Vanguard has seen unprecedented fund flows in the past few years….more than all their competitors combined.*

That said, many investors suffer from biases when it comes to the active vs. passive debate. One, in particular, is the status quo bias. This bias causes one to conclude that passive funds will always outperform active funds after seeing that the returns of the Large Cap passive benchmark (S&P 500) have outperformed 90% of mutual funds over the past 3-5 years. However, I ask that you check your premises. Active vs. Passive is cyclical as seen in the chart below. Money pours into passive, and the stocks in passive strategies get overpriced. The money then cycles back into active. We are precisely at a time when quality active funds should outperform for a long time.

Most people forget that the S&P 500, as a market-cap weighted index, had nearly 50% tech stocks right before the tech crash in 2000 and nearly 40% financials in 2008 before the financial crisis. Cap-weighted indices including the S&P 500 naturally become overweighted to expensive areas of the market as money flows into passive funds.

Typically, indexing does not look good when the market is volatile. Consider the chart below of 3-year rolling returns of SPY (S&P 500 index ETF) compared to the universe of U.S. large cap funds. As you can see, the index fund spent its fair share of time in the bottom two quartiles over the past 20 years, most notably, after the tech crash and financial crisis.

Source: Zephyr StyleAdvisor

I must also point out that most mutual funds are passive investing vehicles. Over 70% of funds are either passive funds or closet indexers (i.e. managers who are active in name, but manage the fund as closely to the benchmark as possible {likely to manage career risk}).* So, it makes sense that the benchmark outperforms most of these funds net of fees. Essentially, these funds are buying the index and charging higher fees than their passive counterparts. Next time you see a statistic claiming that X% of funds don’t beat the index, realize that most of those funds are actually just the index with a fee charged.

Now, what does a truly active fund look like over time? Given patience and an understanding that some years active will underperform, an investor can experience substantial outperformance in the long run. The below chart is a sample of a Large Cap active manager vs. the S&P 500 over 25 years. An investor would have outperformed the market 739%.

Source: Zephyr StyleAdvisor

* http://www.morningstar.com/cover/videocenter.aspx?id=790642

* http://ritholtz.com/2016/10/bill-miller-closet-indexers-killing-active-investing/