By: Samuel Boyd, CFP®
Senior Vice President - Capital Asset Management Group
You’ve likely heard that passive investing beats active management. Warren Buffet has even said it!
From his January 27th CNBC interview, “(Index investors…) will do better on balance than what they will get if they go to professionals … because the professionals, after fees, don't know how to get a better result."
Not so fast. Let’s deconstruct the most commonly referenced, inaccurate, saying in investment management.
It goes something like, “Passive, low cost, indexed portfolios beat the performance of the average managed, active, mutual fund.”
Or, more specifically, from Morningstar’s 2015 Active/Passive Barometer, “The Active/Passive Barometer finds that actively managed funds have generally underperformed their passive counterparts…”. This study found that fewer than 22% of large-cap stock funds beat the market over the 10-year period from 2005 to the end of 2014.
We’ll discuss the material components of the superlative mutual funds shortly but, to say that a broad based, low cost, index beats the cleanest dirty shirt in a hamper of mutual funds is both a disservice to investors and an outright mischaracterization of the options available to the average American.
Allow me to blow your mind. According to a recent study by American Fundsover all rolling 10-year periods during the 20 years ended June 30, 2016, investments in the group of Select Active funds would have generated, on average, 8% more wealth than an equivalent index investment.
Yes, you read that correctly. Feel free to bust that out at a cocktail party and listen for that most quoted, misinformed, statement above. Below is the ammunition to compose an eloquent retort.
But wait, what is a “Select Active” fund? If you take anything away from this article it should be the following:
Select Active funds can be screened using the following paramount characteristics:
1. Low Fees – You bet. Cost reduces return. Reduced returns lower long term wealth accumulation. There is an incomprehensible amount of empirical evidence proving this. Talk about beating a dead horse…we won’t do that here.
2. Manager Ownership – This factor wasn’t available to us until 2005 when the SEC required disclosure of ownership ranging from managers owning nothing up to $1 million invested in their own fund. Now we know who, in a Silicon Valley-sim, is, “eating their own dog food”. To the investment community’s surprise, and frankly my own, those who buy in do so both literally and figuratively; and it works.
Remember your last rental car? Did you wash it? Didn’t think so. In the words of Thomas Payne,
“A body of men holding themselves accountable to nobody ought not to be trusted by anybody.”
However, investors are speaking with their wallets. Assets of index funds have risen dramatically over the years—from $11 million in 1975 to $511 million in 1985 to $55 billion in 1995, leaping to $868 billion in 2005 and now standing at $4 trillion. From 4% of equity mutual fund assets in 1995, the market share of index fund assets grew fourfold to 16% in 2005 and then more than doubled to a record high of 34% in 2015 1.
All this despite two massive declines in the 2001 and 2008 where your favorite index captured most the decline based on the market it tracks. Managers can also add value by limiting downside participation, the downside capture ratio. Remember, if you lose 50% of your fund’s value, you’ll need a 100% return to get back to your starting point.
Based on a study by Aaron Reynolds at Robert W. Baird (Using Morningstar Data) 63% of actively managed funds outperformed the S&P 500 between the turbulent period of 2000 and 2008 by an average of 1.4%. This figure doesn’t just include those Select Active Funds but all active funds available throughout the investing universe at the time.
Some are even making the case for a possible bubble in index funds. From William Ackman’s 2016 letter to Pershing Square Capital Management LP shareholders, “We believe that it is axiomatic that while capital flows will drive market values in the short term, valuations will drive market values over the long term. As a result, large and growing inflows to index funds, coupled with their market-cap driven allocation policies, drive index component valuations upwards and reduce their potential long-term rates of return. As the most popular index funds’ constituent companies become overvalued, these funds long-term rates of returns will likely decline, reducing investor appeal and increasing capital outflows. When capital flows reverse, index fund returns will likely decline, reducing investor interest, further increasing capital outflows, and so on. While we would not yet describe the current phenomenon as an index fund bubble, it shares similar characteristics with other market bubbles.”
In a simpler sentiment from Rob Arnott of Research Affiliates, “The Achilles’ heel of indexing is that when you have a bubble and a stock is trading way higher than it should, you have your peak exposure at its peak price.”2
So, in summation, don’t dog active management, don’t dog the index funds, dog the Dogma. There is a place for both indexing and active management at the table based on your individual goals. When screening for funds in your portfolio combine the holy trinity of low fees, high management ownership, and low downside capture during negative periods and you can further narrow the pack of potential investment options. Fees matter, yes, but ownership and downside capture play a role as well. Perhaps this isn’t Dogma after all – perhaps this is one of those “alternative facts” everyone keeps talking about.
1. Bogle, J. C. (2016). The index mutual fund: 40 years of growth, change, and challenge. Financial Analyst Journal, January/February, 9-13.
2. Loic Lemener (2016), “The Great Debate”, Jan 22, 2016
Securities licensed associates of Capital Asset Management Group Inc. are Registered Representatives offering securities through Cambridge Investment Research, Inc. A Broker/Dealer. Member FINRA/SIPC. Licensed administrative associates do not offer securities. Investment advisory licensed associates of Capital Asset Management Group Inc. are Investment Advisor Representatives offering advisory services through Capital Investment Advisors, Inc. A registered investment advisor. Capital Asset Management Group and Capital Investment Advisors are separate and unrelated companies from Cambridge.
These are the opinions of Samuel Boyd, CFP® and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal.
Investors should carefully consider the investment objectives, risks, fees and expenses before investing. For this and other important information please obtain the investment company fund prospectus and disclosure documents from your Financial Professional. Read this information carefully before investing.