Johann Bornman considers how active and passive funds measure up against the key benchmarks of not losing money, actually aiming to make money and, finally, shooting for above-average returns
The serious debate as to whether active or passive investments are better for a portfolio rages on. Active fund managers point to the possibility for outperformance and the protection of returns on the downside.
Passive proponents on the other hand point to the lower fees, better returns and the pure implementation of a particular asset class - in other words, there are no overweights or underweights of certain sectors and industries compared with active funds.
This debate has produced an exceptional amount of literature and Standard and Poor's even publish a semi-annual report, entitled SPIVA, which compares the performance of active fund managers with their benchmarks.
So how is one to think of whether to include active or passive funds in a portfolio?
One way would be to use the framework of a few simple golden rules - first and foremost, not to lose any money; second to look to make money; and third, once the first two rules have been adhered to, only then to look to make extraordinary returns. This can help investors judge whether active or passive funds is the better option. So how do they compare?
Rule 1: Do not lose any money
The standard view is that active fund managers can invest in defensive sectors and securities and have high cash balances during bear markets. Research done by Vanguard over a 40 year history of US market returns, however, found that in four of the last seven bear markets from 1973 to 2014, active fund managers underperformed the index.
In fact, the same paper found that, over 15, 10 and five-year periods, the median US equity, US bond and non-US equity active fund had greater volatility relative to the market benchmark. So much for protecting your portfolio on the downside when it comes to active fund managers.
Rule 2: Make money
From the SPIVA report cited earlier to the same Vanguard study, the underperformance of active fund managers is quite well known. The latest SPIVA report from the US found that, over a five and 10-year period, respectively 92% and 85% of active large-cap fund managers underperformed the S&P 500 index.
But surely, given the chance for mispriced and unfollowed stocks, small-cap managers would have done better? In fact, 98% of fund managers over a five-year period and 91% over a 10-year period failed to outperform the US S&P 400 Small Cap index. Vanguard also showed that in six of those eight bull markets from 1973 to 2014, active fund managers underperformed their benchmarks.
Performance and fees are often cited as strong arguments for passive investing and really make up two sides of the same coin. The lower fees of passive funds allow for a smaller headwinds when it comes to offering investors better returns.
Is it really only fees that have driven this outperformance though? Given the numbers cited above, if one were able to compare gross returns and accurately account for the survivorship bias of active funds, would they really outperform passive funds over a 10, 15 and 20-year period? There is no data to hand on this though what we do have is strong evidence passive funds tend to adhere to the second golden rule far better than their active counterparts.
Rule 3: Make extraordinary returns
One would expect active funds to run away with this category. By their very definition, passive funds track the index and therefore give you the ‘average' return. No one wants to be average of course. If long-only funds cannot beat the index, surely hedge funds, with their star fund managers, are there to provide these above-average returns one so desperately seeks.
Again, however, if you look at the data, hedge funds, have done far worse than the index. The truth of the matter is that passive funds have given investors far above average returns. The low cost of passive funds mean investors have far lower hurdles to jump when making up the cost of fees. Furthermore by building a diversified portfolio or asset allocation of passive vehicles or exchange-traded funds, the portfolio can deliver above-average returns when compared to the active industry.
It seems pretty clear passive funds make a compelling case to be held within client portfolios. From the low fees to the better performance and the track record of beating active fund managers in both bear and bull markets, passive investing definitely should be considered when looking to invest for the long term.
It is not that active fund managers cannot beat the market but, as the data shows, this cohort is so incredibly small it really only includes the absolute very best and an ever decreasing few of the industry.
Warren Buffet - perhaps the most well-known of these investment titans - made it clear what he thought about passive (and active) investing when he revealed his will advises his wife to invest his remaining fortune into passive funds. That, one might think, is perhaps the ultimate closing argument.
Johann Bornman is product and sales director at ETFmatic
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