The active vs. passive debate

Jan 16, 2014 @ 12:00 am

Runtime: 6:49

Which investment strategy is best to close the underperformance gap all investors face? Gregg Fisher, chief investment officer at Gerstein Fisher, and Daniel Wallick, principal at Vanguard Investment Strategy Group, weigh in.

Video Transcript

On this week's WealthTrack, the active versus passive debate. Two seasoned investment pros argue the case for and against. In a surprising twist, Vanguard principal, Daniel Wallick, presents the active management case while award-winning financial advisor, Gregg Fisher, defends the passive approach. Their arguments are next on Consuelo Mack WealthTrack. There is this big underperformance gap, and how much does behavioral-- behavior affect our returns, both ours as an investor and also as the individual manager, how they behave, and that's why it's so important that they-- -Right. Let me start with the investor. -Yeah. -So, I think it's very challenging for all of us to stick with something, particularly if it's had, say, a difficult run for a while, because for many of us what we wanna do is fix it. Right? We wanna take action and do something to stop the hurt or the pain or-- -Uh-huh. -or the whatever. So, if you have a manager that you had faith in in the past, and they had-- say, they had a good run for five years, but all of a sudden for three years, they've been doing poorly, there's a sense of urgency. Committee-- Investment committees do this. Individual investors do this. You know, we, as human beings, do this. We wanna stop the problem, right? So, what we'll often think about is, well, we should change that manager. -Uh-huh. -There was an incredible study done by some professors down at Emory University, and they looked at institutional investment committees. So-- -Right. This is the smart money, right? -Exactly. They looked at 3,000 of these throughout the United States, and what they found was when they made a hire-fire decision, it typically was they were firing people who had a bad three-year track record, they were hiring people who had historically a good three-year track record, and oddly enough, for the subsequent three years, the reverse proved to be true. -Right, reversion of the mean. -Right. So this sense of, you know, the report card of recent performance is often used as the decision factor, and you really need to stand back and not do that. -So, tell us about how you treat the managers that you've chosen to manage actively managed funds, how you treat them when they have had a period of underperformance, let's say three years. -Right. -So, let me start by saying our average tenure for sub-advised active managers is 13 years, and if you take out the people we've hired in the last five, that number actually rises to 17 years. -So, you stick with the managers that you choose. -Yeah, right. -We really do and the reason for that is if we have faith in their process and their people, all those qualitative things I was mentioning before, unless those have changed, we wanna stick with the manager. Now, there will be those managers who, in a moment of crisis, decide that, you know, they're gonna flip the switch and go from being strategy A to strategy B. Those are the managers we would be most concerned about. You know, why are you changing? It feels like more of a cash flow issue than an investment issue. So, for those people who change for reasons that we don't fully understand or value, that's when we think of making a change, or if there's a personnel change in a company, if, you know, the lead managers all of a sudden are no longer there, that's another reason too. But if the people are the same and the process is the same and the process continues, you know, we're gonna stick with somebody through hard times. -Yup. Some people think that there are certain sectors of the market that-- you know, that call for active management. I mean, we've had somebody on from Morningstar recently, for instance, who said that municipal bonds, it's so difficult to-- You know, you've got to look at the credit worthiness of each individual issue. You can't buy an index fund. You're poorly served by buying index funds. So, therefore, you should, you know, be actively managing munis. I mean, you know, some people say small-cap stocks. Some people say, you know, local-currency bond, you know, funds in the international markets. Are there certain sectors that you really do need to have an active manager? -I think there isn't a sector where you need to have an active manager. I think investors could start with the idea that a market-based portfolio that's globally diversified across all asset classes is a really great place to start and maybe even end. However, to the extent an investor wants to consider active management, we do think that there are places where they're more likely to have success than others. For example, both in the U.S. and internationally, there seems to be evidence that growth investing is a place where you'd have a better shot at investing with active managers than perhaps value investing. There's a lot of evidence of this when you look at rolling 15-year periods through the test of time. There seems to be something about the ambiguity of growth stocks and valuing them and a variety of other things that we think show up in the investor behavioral data that cause active growth strategies to have better odds than value strategies when it comes to using active management. But again, I would say that this is more about a personal choice because, the point we were making earlier about investor behavior, the research we've done shows that on average, investors lose about two percentage points per year just due to their behavior. This is more important than fees and, frankly, even more important than taxes. -These are timing their funds that Daniel was talking about. -Right. -That's exactly right. So, I think what's important for an investor is, well, perhaps, they might consider some active management in their portfolio, and maybe it's growth strategies or some other area where they feel they have a good shot at winning -- winning meaning returns better than the benchmark, net of fees and taxes. However, I think what's really important is that they invest in things they feel comfortable with where they can stay invested, think strategically, because if they're invested in something where they're not comfortable, they'll never see the long-term results that most investors are entitled to. And this 2% investor drag is very significant, and I think it's the most important point from our perspective. -Right, and very significant. Your research has shown over time it's just-- it's huge. -Yes. -So, any sectors that you think really that you shouldn't invest in an index fund, that you should invest with active managers in particular? -No. No. We would say what you wanna do is start out with a strategic asset allocation, use indexes to sort of build that out as a starting point much like Greg said, and then move off of that to the extent that you'd be comfortable with active. Active has certain attributes that people, we would say, people really need to be comfortable with to undertake and that's-- in particular, there's variability in the returns. So, relative to the index or the benchmark, you're gonna be up some years, you're gonna be down some other years, you're gonna be down for many, many years. Unless you're comfortable with that, you shouldn't be going into active, and the other is if you can acquire active at a reasonable cost. Right? Again, we would say those two factors-- live-- if you can live with the variability and you can acquire it at a reasonable cost, then there's an opportunity for active to be useful.


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