Following the premature publication of his obituary, Mark Twain was famously quoted as saying, “The reports of my death have been greatly exaggerated.” The same might be said of the manner in which active money management has been portrayed over the past few years.
For some time, it has been almost impossible to find an article about investing or personal finance in which the author doesn't conclude that active management tends to underperform the market over time and that investors are better off selecting a handful of indexes.
Although active management is a little more expensive and sometimes riskier, skilled active managers can enhance investors' wealth.
Many studies make compelling cases for both sides, but one approach can't be proved superior. In fact, each has a role to play in most portfolios.
In a 1991 Financial Analysts Journal article, Nobel-winning economist William F. Sharpe argued that active managers underperform passive ones because of higher fees and expenses, but his position rests on some questionable assumptions.
For one, he held that passive investors own the “market” portfolio, made up of all outstanding stocks in proportion to their market capitalization.
Mr. Sharpe also supposed that no large investor group systematically earns returns that are different from the market and that investments are limited to securities available in the market.
In fact, rather than buying the market, passive investors replicate the holdings of a specific index, with most indexed dollars invested in just 500 stocks. There are two types of index, and both of them reflect a buy-high, sell-low approach.
The inclusive indexes from Russell Investments contain all stocks in proportion to their market cap. The costliest have the highest weight.
In the other type of index, from Dow Jones & Co. Inc. and Standard and Poor's Financial Services LLC, a committee selects holdings. For both types, the largest positions are in stocks that have had high returns.
Last March 31, Apple Inc. (AAPL) was at about $610 a share and made up 4.4% of the S&P 500. Three years earlier, it had been $110 and 1.4%.
Does anyone want to own three times as much Apple after it has risen 450%?
The flows into indexed products are creating openings for active managers. Dollars going into market-indexed vehicles are invested proportionately, based on market cap, in each stock in the index, regardless of its valuation or the company's fundamentals.
The flows into passive vehicles mean that active managers have less influence at the margin to move stock prices to reflect true value. Outflows from actively managed accounts exacerbate the mispricing, as attractively valued stocks must be sold to raise cash.
Paradoxically, this process creates more mispricing opportunities for active managers to exploit.
Sector exchanged-traded funds give retail investors focused chances to buy high and sell low as they become interested in a sector after a period of strong returns. Large inflows into sector funds not only create mispricing in stocks but may make whole sectors unattractive from a valuation standpoint.
Index construction techniques aren't a passive investor's friend in such environments. The technology sector was one-third of the broad market indexes at its peak in the first quarter of 2000.
Twelve years later, with the Nasdaq Composite Index down 40%, that sector represents just 20% of the indexes. Active managers tend to lag in such momentum-driven environments but ultimately win the race, as they avoid the bubble deflation that follows.
As much of a financial adviser's effort likely is directed at ensuring that clients have a comfortable retirement, exercising fiduciary duty involves carving out a spot in their portfolios for the upside potential that skilled active management provides.
Richard Snow is founder, president and chief investment officer, and David Jack is managing director and product specialist, at Snow Capital Management LP.