Counseling clients: Why a passive investing approach still makes sense

An article in the Wall Street Journal kicked off the new decade with this headline: “Active did better in “09.” CNBC pundit Jim Cramer of “Mad Money” went one step further, declaring 2010 the “year of active investing.”

These aren’t pronouncements that financial advisers can afford to ignore.

Let’s say you recommend a well-managed, diversified portfolio and a passive investment approach.

These headlines might make your clients nervous that they are missing opportunities. You need to be prepared to reassure them with sound advice and analysis.

A long-term perspective helps. Instead of limiting the comparison to last year, you may want to consider some of the longer-term lessons of the Great Recession to offer better insight.

Clients need to hear that Wall Street has a notoriously bad forecasting record. In fact, Wall Street’s consensus forecast has failed to predict a single recession in the past 30 years, and most pundits were as surprised by the Great Recession as the rest of us were.

Every January, USA Today asks top investment strategists to offer their outlook for the year ahead, including where they think the S&P 500 will end the year. Looking back now on the forecasts made for the markets at the beginning of 2008, many of them turned out to be quite optimistic.

At the end of 2007, the New York newspaper Newsday sampled “eight major Wall Street Securities firms” and came out with an average price target for the S&P 500 by year-end 2008 of 1,653, representing a 12% rise for the year.

We now know that the S&P 500 declined by 37% in 2008, ending at 903. The most pessimistic strategist was off by more than 600 points, and none of these strategists predicted the down direction of the market correctly.

If experts can’t even predict recessions or the direction of the markets, how can we expect active managers to pick individual stocks when performance is so sensitive to economic and market conditions?

Many investors think that active managers earn their keep in bear markets because they avoid losses by hand-picking superior individual stocks or by shifting out of stocks altogether before steep market declines occur.

Let’s look at the numbers to see if the data support that view.

Standard and Poor’s has been measuring the performance of active managers against its index counterparts for several years now. Its Indices Versus Active Funds Scorecard specifically focused on the bear market of 2008 and concluded that “the belief that bear markets favor active management is a myth.”

In the same study, S&P identified similar results for the 2000-02 bear market.

In this bear market and the one in 2008, a majority of active funds underperformed their respective S&P index benchmarks for all U.S and international equity asset classes. In aggregate in 2008, actively managed funds underperformed the S&P 500 by an average of 1.67%.

In addition, the study concluded that over a full market cycle for the five-year period ended Dec. 31, 2008, the S&P 500 outperformed 71.9% of actively managed large-cap mutual funds, and the S&P SmallCap 600 outperformed 85.5% of actively managed small-cap funds. The results were similar for international funds, with the S&P 700 outperforming 83.5% of international funds.

Whatever the markets are doing, active managers must face the fact that the performance of individual stocks can differ greatly, even though stocks collectively have historically provided strong returns over long investment horizons.

From 1980-2008, the U.S. stock market generated an annualized return of 10.4% (using the University of Chicago’s CRSP total-market-equity database to represent the U.S. market). Surprisingly, all the market’s gains were produced only by the top-performing 25% of stocks.

During the same period, the remaining 75% of the stocks in the total-market database collectively generated a loss of 2.1%. This example demonstrates the difficulty in selecting the individual stocks that will perform better or even in line with the broad equity market.

Attempting to enhance your returns by seeking out the needles in the haystack introduces an additional layer of active risk and the potential for increased volatility. A portfolio of even the most carefully chosen stocks could easily wind up with none of the best-performing stocks in the market, and thus could possibly produce flat or negative returns for many years.

According to an article by William J. Bernstein in the May issue of Money magazine, the only way you can be assured of owning all of tomorrow’s top-performing stocks is to own the entire market.

Although past performance is no guarantee of future results, this sounds like compelling evidence for why a broadly diversified, passively managed portfolio may offer the most sensible path to help your clients achieve their investment goals.

Joni L. Clark is a certified financial planner and chief investment strategist at Loring Ward, which provides asset management programs and back-office support for more than 750 independent investment advisers and their clients.