There are some topics that you just don’t discuss. We all know what they are. We can recall a time long, long ago, pre-COVID and travel lockdowns, when these topics caused heated debates. Yes, we have all been at a cocktail hour after a day-long conference when a particular topic comes up, and suddenly even the most polite people turn downright mean. We all fight to stay out of it, but we inevitably get pulled in; we just cannot help ourselves. No matter where you fall along the spectrum of views, “active versus passive” is that topic we just shouldn’t bring up.
Why All the Fuss?
I can recall a point early in my career when I inadvertently entered the fray in this debate. It was 2011, and I was a newer member of my firm’s investment committee. I was researching the usage of ETFs by institutional investors. As we discussed performance and other issues, I suggested, “We should consider ways to leverage ETFs. Why wouldn’t institutions just use ETFs for large parts of their portfolio given the lower cost of implementation and the challenges with active management.”
In a firm whose primary business was active management, passive investments were an anathema. “That’s just the old active-versus-passive debate. Institutions won’t invest passively,” said my colleagues. I felt that this time was different (famous last words, I know).
At the time, approximately 50% of U.S. ETF assets were held by institutional investors . While the early uses were by hedge funds and as temporary holdings to equitize cash, the uses were expanding, as were the types of institutional users. Why the change? Coincident with this increased usage of ETFs was a reevaluation of the value of active management. Much like today, active managers were challenged with beating the benchmark. ETFs were an efficient, liquid way to get access to broadening range of available sub-asset classes. Everything was becoming passively investable. By the time I left the firm, we were leveraging ETF overlays as complements to active, multi-manager portfolios to enhance high-conviction sector and country exposures.
They say history doesn’t repeat itself; it rhymes. In the case of this debate, that makes a lot of sense given the long bull-run in the U.S. market prior to 2020. The conversations about active management are the same. But, are they warranted? Maybe.
To make that determination, we can look at a Lipper universe of active U.S. Large Cap Core funds. From 2012, the first full year after that fateful committee meeting, through the end of the third quarter of this year, the Russell 1000 Index beat an average of 67% of managers every year, as well as through the end of the third quarter. In light of that, it’s understandable that questions about active management continue to swirl.
To continue believing in active management is to have the faith of a Los Angeles Clippers fan holding on for a championship. Well, maybe you don’t need that much faith. So why the ongoing debate? The answer is, “it’s complicated.”
Active management is a tough business, and a zero sum game. Esteemed professor William Sharpe and prolific writer Michael Mauboussin have shown this to us. Putting aside the age-old “skill vs. luck” question, if we assume some degree of manager skill, why did two-thirds of them underperform the benchmark? If we look at the Russell 1000 Index and its year-to-date total return through September 30, 2020, it returned 6.40%2. If we first isolate “Big Tech,” represented by the FAANGs and Microsoft, then proportionately re-weight “Big Tech’s” return and the return of “Everything Else” so that the component weights for each group sum to 100%, we see that there is more than meets the eye.
In the figure “A Tale of Two Indices” we see that the return differential between these two groups is substantial. The average weight to the technology stocks, year-to-date, is approximately 19% versus 81%2 for the remaining index constituents. Tech stocks screamed ahead and the rest of the index constituents did the best they could. If we look only at these 10683 companies that detracted from the index year-to-date, we see that approximately 85% of active managers outperformed. In fact, for almost every year since 2015 (2016 being an exception) between 60% and 75% of active funds in the universe outperformed ‘Everything Else3” as shown in the “Active Manager Outperformance” table, below. So, as I read various articles about the death of active management, I’m reminded that the great debate rages on unresolved, where the proverbial answer to the question of “active or passive?” remains “it’s complicated.”
Focus on Clients
There is value in incremental return, which is why we continue to believe in the potential of active investing. Extra performance net of fees and taxes represent real money to end clients. Though this debate over active and passive may continue on, there are millions of investors in need of advice that can help them to achieve their goals over time. What is their view of active versus passive? To put it plainly, if we focus them on outcomes, they probably don’t care as long as they can send their children to school, buy that second home, or retire comfortably as planned. As advisors, they are looking to us to help make that happen.
For some, portfolios comprised of fully active investments may be the right solution. For others, portfolios comprised of lower-cost, passive ETFs may be the right solution. As an advisor, the key is to know your client, to understand their goals, and to remain flexible. A well-diversified portfolio is usually the right answer. Whether that is implemented with active investments, passive investments, factor-based products designed with tilts to stock characteristics like momentum, or some combination thereof is really a matter of preference. Yes, if you can identify skilled managers, there can be value in that. But, there can also be value in investing passively or using a hybrid approach that combines the two or incorporates factor-based products. In the end, while the debate rages on, clients need us to focus and to be nimble. In the meantime, let’s talk about politics instead. It’s much less polarizing.
1 Market structures and systemic risks of exchange-traded funds, https://www.bis.org/publ/work343.pdf, Srichander Ramaswamy
2 Russell 1000 Index Factsheet, https://research.ftserussell.com/Analytics/Factsheets/Home/DownloadSingleIssue?issueName=US1000USD&IsManual=true, FTSE Russell
3 Source: Factset, SEI.
4 Source: Factset, SEI. Returns for "Everything Else" represent the marginal contribution of the included firms divided by the sum of their index weights. Returns for "Everything Else" exclude Facebook Inc., Apple Inc, Amazon.com, Inc., Alphabet Inc. (Classes A and C), and Netflix, Inc., while these firms are represented by "Big Tech."
There are risks involved with investing, including loss of principal. Diversification may not protect against market risk. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only and should not be interpreted as legal opinion or advice.
Russell 1000 represents the 1000 largest companies by market capitalization in the United States. It is used to measure the activity of the U.S. large-cap equity market.
Index returns are for illustrative purposes only and do not represent actual investment performance. Index returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
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