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How the investor is lost in the active versus passive debate

Let's start a debate about how best to construct portfolios that meet the needs of our clients, and that can withstand the test of time through all market conditions

Jul 25, 2017 @ 1:19 pm

By David M. Haviland

Why is active losing out to passive? It's because most active managers have a dual mandate to serve both institutional and retail investors. The mandates, or expectations, of these two types of investors are vastly different, and they are in direct conflict. This conflict creates failure in the eyes of the typical retail investor, and this very often forces the retail investor into making the wrong decision at the wrong time. Let me explain:

THE INSTITUTIONAL MANDATE

An institutional mandate dictates that the manager follows their investment process, and that the manager stays fully invested according to this process at all times. Institutions want the management style to be pure as part of a larger portfolio construct. As a result, if the market enters a period of failure, the active manager is severely limited as to selling or the introduction of alternative assets to try to mitigate loss.

The influence of institutions on active managers is profound. During bear markets, if management deviates from their process, they are typically fired. This is how most large endowments and institutions think. Why? Institutions are typically able to withstand a large loss because their time horizon is long enough and their discipline is strong enough to endure a bear market.

THE RETAIL MANDATE

In stark contrast, the average retail investor has a very different expectation of an active manager. Retail investors think their active manager is going to grow their assets during good times and even sideways markets. But when markets enter periods of failure, such as the 2000-02 and the 2007-09 bear markets, the retail investor expects the active manager to sell positions and to try to protect the assets in their account.

In addition, according to a December, 2015 Ned Davis Research study, the average retail investor now holds stocks and/or mutual funds for less than one year, which is far too short a time horizon to deal with multi-year bear markets and the time required to recover.

These expectations are in direct conflict and the retail investor is going to lose to the institutional mandate every time.

WHAT DOES THE AVERAGE INVESTOR REALLY WANT?

Based on decades of working with investors, we find the average investor wants a manager to make the buy and sell decisions for them. This is what ETF strategists do. Yet, since most active managers do not sell, the average investor is forced, based on their emotions, to make their own sell decisions, and typically just fire the manager. These emotional decisions are most often made at the worst possible time, at or near the bottom of a bear market. As the annual DALBAR study shows year after year, the average equity investor only receives about 1/3 of the U.S. Equity market returns over time.

Why? Because in the debate between active and passive, we forget that we are talking about people. We invest money to try to improve our futures: to reach our goals, such as education, buying a home or living a comfortable retirement. In a bear market, or even a severe correction, our futures are threatened. The typical Investor forgets about his or her time horizon and loses discipline. They don't want to or mean to, but they become subject to the emotional decision of trying to protect their future.

It is time to end the distracting debate between active and passive. It is the wrong debate! Our industry needs to focus on providing solutions that meet the expectations and needs of the average American investor: Growth strategies with defensive capabilities. When you hear the words "Just stay invested," they are most often uttered by either a very wealthy person or someone who has never sat across the table from clients seeking help.

Let's start a debate about how best to construct portfolios that meet the needs of our clients, and that can withstand the test of time through all market conditions. Let's talk about how best to blend strategic and rules-based, tactical managers. What is more important to Americans, avoiding a few dozen basis points of expense or a few dozen percentage-point decline in a bear market?

David M. Haviland is managing partner and portfolio manager at Beaumont Capital Management.

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