Wall Street is witnessing an epic battle for investors’ dollars pitting “active” investment versus so-called “passive” investment. On the active side are iconic mutual fund families such as Fidelity, T. Rowe Price, and American, and Franklin Templeton. On the passive side are such heavyweights as Vanguard, BlackRock, and State Street.
Active investment involves portfolio managers selecting which securities to hold in a portfolio. It is the Warren Buffet, Peter Lynch, John Templeton approach to investing. Passive investment involves no subjective evaluation of securities but rather a set of rules to construct portfolios. For example, the Vanguard S&P 500 Index Fund holds stocks in the S&P 500 Index in direct proportion to their market capitalizations in that index. The rule is: If a stock is x% of the S&P 500 Index, buy/sell shares of that stock so as to maintain that percentage on a daily basis. Rules for passive investing can be based on other metrics such as revenues or dividends, to name two popular alternatives. Also, in theory any index can be used as the universe for applying the rules.
Active investment managers oversee more than $10 trillion of investor assets in the U.S. compared to $5.4 trillion for passive managers. Passive investing, however, has been gaining market share every year since this bull market began in March, 2009. As investor funds flow into passive investments, they get invested according to the applicable rules. This can create problems if you believe, as we do, that valuation matters. Why is that? Because most passive investing ignores even thinking about valuation measures such as price-to-earnings, price-to-revenue, or dividend yield. Passive investment applies its rules and invests accordingly even if a security has become overvalued relative to its history.
This approach had disastrous consequences for investors in NASDAQ funds back in 2000. Passive funds were forced to buy stocks such as JDS Uniphase, Qualcomm, and Intel at absurd P/E multiples. (Well, absurd in the eyes of traditional value managers!) Not one of those stocks has returned to its 2000 highs. Of course in 1998-1999, seven to eight years into the bull market which began in 1991, passive investing looked brilliant. Some value managers believe recent passive investing has been one source of the relentless, low volatility advance in the major indices over the past eight years.
So why has passive investing become so popular? Certainly a key reason is lower management expense. Low fees are THE major marketing theme for promoters of passive funds. Vanguard’s S&P 500 Index Fund charges just 14/100% to implement its passive approach. That means a $100,000 investment pays only $140 annually. In contrast, American’s Growth Fund of America charges 66/100%, or $660 annually. Fortunately for long term investors in that mutual fund, the fund has easily covered the expense difference going back to 1998. (Not every year, but enough to give it a solid cumulative advantage over the index.)
But passive investing adherents such as Vanguard’s retired CEO John Bogle assert that Growth Fund of America is the exception not the rule. Active funds as a group have failed to exceed their benchmarks after accounting for fees. Bogle thinks individual investors shouldn’t even bother trying to find funds which might outperform.
We think a baseball analogy might be useful. In 2017 the average Major League batting average was .255. If you were a manager would you be OK selecting a .255 hitter or would you seek a player with prospects for batting better than average? After all, over the past 20 years about 21% of Major League hitters each year batted over .300, the gold standard for outstanding performance at the plate. Isn’t it worth trying?
Nevertheless, since active investing underperforms the benchmarks from time to time, some active investors see a role for limited use of passive investments. Investing a portion of a portfolio passively can help smooth out performance. Passive investments can also serve as temporary “place holders” while value-oriented securities are added gradually to a client’s holdings.
Interestingly, some research suggests that active investment tends to run countercyclically to the overall market. For example, in 2000 66% of actively managed funds outperformed the S&P 500. In 2007 53% outperformed. Investors who understand the importance of avoiding large drawdowns can recognize the importance of those findings. Active management is most valuable in troubled market environments. As in 2000 and 2007, those environments seem to arrive after a long stretch of benign market performance. We have no doubt that active investing, particularly the value style, will have a chance to shine again.
Posted on Jan 19 2018
by Bill Miller