Many investors confidently tell me they have discovered the secret to investing: It’s all about passive.
I’m glad they are happy and comfortable with their investment strategy. Unfortunately, I think they are missing some important facts. Most index funds and exchange-traded funds (ETFs) are below-average investments. Here’s why.
Fidelity’s study compares strategies
Recently, Fidelity published a study (page 11 in this link) that shows active investment management beat passive in 12 of 18 investment categories (there was one tie). The study also displays the excess returns. There was only one investment category with significant passive outperformance: large cap growth. In all other categories where passive outperformed active, the excess returns are minimal (less than 1%).
However, in those categories where active beat passive (67%, or two-thirds of all categories), the excess performance was almost always at least 1% (all returns in the study are net of fees). I know, 1% doesn’t sound like a lot, but compounded over a 40-year working career it adds up to a lot of money.
Active beats passive in most investment categories because…
Inefficiencies still exist
Three of the six asset classes where passive beats active in Fidelity’s study are large cap value, large cap blend and large cap growth.
This shouldn’t come as a surprise to anyone. U.S. large cap stocks are the most analyzed securities in the world. It is hard for anyone to discover a fact about Apple that a lot of other people aren’t already aware of and that isn’t already reflected in the price of Apple’s stock.
Although it is difficult for active managers to beat their indexes in asset classes that are highly researched and followed, there still are many asset classes where inefficiencies abound. Those investment management firms that have research expertise and managerial talent in these areas can — and do — significantly outperform their indexes over a full market cycle.
Passive captures 100% of every market downturn
I have never understood the acceptance that proponents of index fund investing have of capturing 100% of every down market move. Supporters of passive investing seem very comfortable with this major flaw.
Index funds are absolutely guaranteed to absorb 100% of every market downturn. An important feature of actively managed funds is that a manager can sell out of positions before capturing an entire market crash. Although not every active manager is able to accomplish this, many do. This may be the strongest argument for the use of actively managed funds.
Misperception of active management exists
There is a widely held belief that all active managers should outperform their fund’s indexes every year. That’s nonsense. An actively managed fund needs to be evaluated over a full market cycle, not just one or two years.
Keep in mind that some active managers are very good at defending your investment against loss, but not quite as skilled at outperforming an index during a rising market. That’s not a bad thing.
In no industry I know of are 100% of participants out-performers. Yet many feel that active management is not a successful investment strategy because every active manager does not beat their benchmark index every year.
Yes, there are some active managers whose results are bottom-quartile. Don’t invest with them. Invest with top-quartile managers in every asset class when choosing actively managed funds.
Liquidity concerns with ETFs
There is concern from many investors about the liquidity of ETFs especially during significant market volatility. The more thinly traded the ETF, the more likely it will have pricing issues during periods of market stress. Also, those ETFs that tend to be unique in their composition are thought to be subject to mis-pricing during periods of market volatility. With over 2,000 ETFs in existence, many feel at least half are subject to liquidity problems.
Passive returns no better than average
Passive investing locks an investor into an investment strategy that guarantees average returns each and every year. I don’t talk with many investors who are comfortable with average returns year-in and year-out. Most investors I know feel they should beat the market each year and are unwilling to accept average performance.
The winning formula uses a mix
Without question, the best way to build a great investment strategy is to use index options for those few asset classes that are widely covered and researched and actively managed choices for all other asset classes where inefficiencies still exist. It is clear that passive outperforms in the large cap asset classes, but in nearly every other investment category, active management appears to be the better choice.
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