Which method reigns supreme in the battle of active investing versus passive investing? Well, that depends on market conditions and a host of variables.
The debate was reignited Tuesday among a group of experts on InvestmentNews' webcast “Point-Counterpoint: Active vs. Passive.” Jim Rowley, senior investment analyst at Vanguard's investment strategy group, chatted about passive investing and its intersection with active investing. Taking up the discussion on active investing was Rob Almeida, institutional portfolio manager on U.S. mid- and large-cap growth offerings at MFS Investment Management.
“In my career, the dialogue on active and passive has always been there,” Mr. Almeida said. “During periods of underperformance by active managers, the dialogue would go up, and as market conditions shift or fade, active managers would be rewarded for their work to outpace benchmarks.”
Indeed, we're in a critical period at the moment, as we're enjoying a seven-year bull market and observers believe that a rise in rates is coming. It's also no secret that assets are flocking toward passive management funds.
DISTINCTION BETWEEN SKILLED, AVERAGE MANAGERS
Mr. Almeida drew a line between active managers whom he deemed skilled and were in the 25th percentile of peers, versus those who were merely average. In a chart depicting average three-year rolling period excess returns annualized from 2005 to 2014, he showed that skilled active managers beat their merely average counterparts by leaps and bounds. For instance, in the 2005-2014 period, average active managers had negative annual excess returns (over the S&P 500 Index) averaging -0.61% in U.S. equities. Meanwhile, skilled managers had average annual excess returns of 0.98% in that same category.
The difference was starker for global equities: Average active managers had annual excess returns (over the MSCI World USD Index) averaging 0.64%, compared with 2.90% for skilled active managers.
“Active managers as a universe on average may underperform their benchmark over time, but those with skill — those with a strong, repeatable process that can isolate their strengths and integrate risk management techniques to de-emphasize their weaknesses — have added value over time,” Mr. Almeida said.
Skilled active managers really stand out during periods of high dispersion in the S&P 500 index — when there's the greatest difference between highest and lowest stock returns. Another chart Mr. Almeida presented measured excess returns of U.S. large-cap blend active managers based on dispersion in the S&P 500 from 1990 to 2014. Under more dispersed markets, skilled active managers had excess returns of 3.88%, compared with -0.31% for the average active managers.
It's worth noting that dispersion tends to grow over time, hence company fundamentals tend to matter more over a longer period of time than a shorter one. It takes time to reap the rewards of skilled active management.
“Managers with skill who are afforded a reasonable time horizon have a platform to add value, while the average manager and those with less time or a shorter time horizon should have more difficulty doing so,” Mr. Almeida said.
On the other hand, Mr. Rowley said Vanguard views the active versus passive battle as more “active and passive.”
“They are part of the same universe,” he said. “It reflects management styles in the same universe of opportunities.”
But what makes indexing work? It's a matter of expenses over the long run. “One of the advantages of indexing is that it takes the average return, but because of its cost advantage, which compounds over time, indexing wins out over the active manager,” Mr. Rowley said.
“It's not that case of any one manager can't beat the market, but the majority can't,” he added.
Further, Mr. Rowley pointed out that dispersion has been fairly consistent going back to the 1990s, and many index constituents have either outperformed or underperformed the index by at least 10 percentage points. “Over the past several years if not nearing two decades, there's been ample opportunity for active to outperform,” Mr. Rowley said.
Fellow panelist Bob Rice, managing partner of Tangent Capital, warned that indexing has had a great run, but it's not permanent.
“Robo [advisers] take indexation to its logical extreme; you're in danger of having an asset-bubble-blowing machine,” he said. “You put all the dollars into the same investments and they'll keep rising. But at some point the party comes to an end.”
However, there are different scenarios that may work in favor of either strategy.
“The case for indexing is cyclical in periods where the dispersion of returns is low, and for whatever reasons are driving that, people are overpaying for market beta,” Mr. Almeida said. “If advisers are trying to diversify risk, one way to diversify and smooth it out is to have a blend of passive and active.”
As for active management, Mr. Rowley suggested advisers consider cost and exposure. “If you come across an asset class that's a highly optimized index fund that comes at a high expense ratio, where I can get a broadly diversified actively managed [fund] at a lower cost,” he said, “well, I'd turn my attention toward that active manager.”