Reposted from www.seekingalpha.com
There is an enduring debate about active versus passive management.
There are advantages and disadvantages to each strategy that investors should consider.
In this series, I will provide investors with an overview of the various strategies, and provide information that will help them select what is best for them.
I will explore Passive Investing in this piece, followed by various forms of active management in Part II.
The enduring debate among financial practitioners is whether active or passive management of portfolios is best. In this series, I want to go over four main strategies, and explore in detail the pluses and minuses of each, and who benefits most with each strategy. With this information in hand, you can be better able to select the strategy that works best for your specific situation, or, if applicable, that of your client.
Strategy 1: Passive Management
Objective: The passive investor would argue that markets are efficient and thus there is no use in trying to beat them. Thus, the objective of passively managed funds, is to buy all the stocks in a particular market, such as the S&P 500, and track the performance of that index. Because we have no way of knowing which stocks will beat the market and which will not, the passive investor would reason, you are better off buying the entire market at a very low cost, and taking the return provided by ‘the market’.
Best For: Passive investing is best for investors who want to track the market at a very low cost, and are not concerned with beating the market. Passive investors simply own the whole market, and receive the return of the index, minus any expenses.
Advantages: The advantages of passive investing are many.
- The strategy is supported by many Nobel Prize winners, and highly successful investors. Research continues to support this strategy because of the poor results of active management, and because of the research demonstrating that markets are efficient. (1) More information supporting this conclusion is included in the ‘Further Research’ section.
- Research by S&P, included in the ‘Further Research’ section below, demonstrates that over long measurement periods, active managers have a difficult time beating the passive index, which means that instead of obtaining average returns from passive investing, the index fund is actually obtaining very high returns relative to their active fund peers. (2)
- Additional research by the S&P, included in the ‘Further Research’ section below, demonstrated that for those funds that do beat the index, it was very difficult for them to continue to do so from one year to the next. (3)
- By buying the whole market, your returns tend to correlate to the market averages, with little or no tracking error.
- In addition, index funds, can be purchased at rock bottom fees as low as 0.04%. The less you pay in fees, the more you have available to take advantage of compounding over time. Every dollar paid out in expenses, loses the ability to compound and add to your wealth over time.
Disadvantages: The disadvantages of index funds are:
- You are buying the whole market, which means you own some really great companies and some not so great companies.
- Additionally, because you are tracking an index, you are guaranteed to underperform the market every year after costs and expenses.
- Index funds also do not give any consideration to the prices they pay for securities. Because traditional index funds are weighted, by market capitalization, as stocks get larger and more expensive they make up more and more of the index. This seems counter-intuitive to the very principles of investing, which tell investors to buy low and sell high.
- There are many structural issues with index funds, such as their inability to act like owners and represent the interests of shareholders. Research continues to prove that index funds vote with management the majority of the time as you can see in the ‘Further Research” section below. (4)
1. A Sampling of Research Supporting Market Efficiency
– George Gibson (1889) wrote the book, “The Stock Markets of London, Paris, and New York,” mentioning the concept of efficient markets. Gibson wrote, “when shares become publicly known in an open market, the value which they acquire may be regarded as the judgment of the best intelligence concerning them.”
– Fama (1965) defined an efficient market for the first time in his empirical analysis of stock market prices in which they conclude that they follow a random walk.
– Samuelson (1965) provided the first real arguments for efficient markets in his paper, “Proof,” that properly anticipated prices fluctuate randomly.
– Fama et al. (1969) undertook the first ever event study (although they were not the first to publish), and their results lend considerable support to the conclusion that the stock market is efficient.
– Published in 1970, the definitive paper on the efficient markets hypothesis is Eugene F. Fama’s first of three review papers: ‘Efficient Capital Markets: A Review of Theory and Empirical Work’ (Fama, 1970). He was also the first to consider the ‘joint hypothesis problem’. Granger and Morgenstern (1970) published the book, “Predictability of Stock Market Prices.”
Ellis (1975) published the article, “The Losers Game,” in the Financial Analysts Journal. The investment management business (it should be a profession but is not) is built upon a simple and basic belief: Professional money managers can beat the market. That premise appears to be false.
Malkiel (2003) examined the attacks on the EMH and concludes that stock markets are far more efficient and far less predictable than some recent academic papers would have us believe.
Malkiel (2005) showed that professional investment managers do not outperform their index benchmarks and provides evidence that by and large market prices do seem to reflect all available information.
2. Research on The Failure of Active Management
The 2017 SPIVA Scorecard demonstrated a consistent long term trend that active managers, in the aggregate, have trouble beating the index.
“over the 15-year investment horizon, 92.33% of large-cap managers, 94.81% of mid-cap managers, and 95.73% of small-cap managers failed to outperform on a relative basis.”
The 2016 SPIVA Scorecard has put together an excellent analysis showing that active funds do not beat the index. It states:
“Given that active managers’ performance can vary based on market cycles, the newly available 15-year data tells a more stable narrative. Over the 15-year period ending Dec. 2016, 92.15% of large-cap, 95.4% of mid-cap, and 93.21% of small-cap managers trailed their respective benchmarks.”
2015 SPIVA Scorecard Results:
3. S&P Research on Persistence
“out of 1,034 large-cap funds that existed in the universe as of Sept. 30, 2013, only 19.73%, or 204 funds, outperformed the S&P 500®. In the following year, 15.69% of those 204 funds outperformed the benchmark. By the end of the third year, none of those original 204 funds were able to outperform the S&P 500 on a consecutive basis.”
4. Research on the Structural Challenges of index funds
It may be said, with some approximation to the truth, that investment is grounded on the past whereas speculation looks primarily to the future, but this statement is far from complete. Both investment and speculation must meet the test of the future; they are subject to its vicissitudes and are judged by its verdict. But what we have said about the analyst and the future applies equally well to the concept of investment. For investment, the future is essentially something to be guarded against rather than be profited from. If the future brings improvement, so much the better; but investment as such cannot be founded in any important degree upon the expectation of improvement. Speculation, on the other hand, may always properly-and often soundly derive its basis and its justification from prospective developments that differ from past performance…The individual investor should act consistently as an investor and not as a speculator.” – Benjamin Graham, Security Analysis
When you look across the index universe. The top three index providers are owning more and more of corporate America, giving index funds more power over shareholder proposals. This has real consequences for capitalism that more investors should be concerned about.
“Every new indexed dollar goes to the same places as previous dollars did. This “guarantees that the most valuable company stays the most valuable, and gets more valuable and keeps going up. There’s no valuation or other parameters around that decision,”… the result will be a “bubble machine”-a winner-take-all system that inflates already large companies, blind to whether they’re actually selling more widgets or generating bigger profits. Such effects already exist today, of course, but the market is able to rely on active investors to counteract them. The fewer active investors there are, however, the harder counteraction will be.” – New Yorker Is Passive Investment Actively Hurting The Economy?
A 2017 paper looked at the effect the big three – Vanguard, BlackRock (NYSE:BLK), and State Street (NYSE:STT) – have on corporate ownership and the creation of new financial risks for capitalism. The authors from the University of Amsterdam explore the challenges with passive investing being concentrated in a few firms, versus the advantages of competition and the fragmentation of active investing. Because active investing is more fragmented, it results in corporate ownership being spread around to dozens upon dozens of firms. This prevents any one firm from having potential undue influence over corporate management.
The authors state:
“When we talk about the power of large asset managers, we are concerned with their influence over corporate control and as such their capacity to influence the outcomes of corporate decision-making. Shareholders can exert power through three mechanisms. First, they can participate directly in the decision making process through the (proxy) votes attached to their investments. In a situation of dispersed and fragmented ownership, the voting power of each individual shareholder is rather limited. But blockholders with at least five percent of the shares are generally considered highly influential, and shareholders that hold more than 10 percent are already considered “insiders” to the firm under U.S. law. The growing equity positions that passive asset managers hold thus increase this potential power.”
“The size of a node in the visualization can be interpreted as the potential shareholder power of the particular owner within the network of control over listed companies in the United States. Thus, when seen together, the Big Three occupy a position of unrivaled potential power over corporate America.
When Vanguard pioneered its index fund concept in the mid-1970s it was attacked as “un-American,” exactly because they held shares in all the firms of an index and did not try to find the companies that would perform best. Therefore, the new tripartite governing board of BlackRock, Vanguard, and State Street is potentially conflicting with the image of America as a very liberal market economy, in which corporations compete vigorously, ownership is generally fragmented, and capital is generally seen as “impatient.” Benjamin Braun has argued that passive investors may, in principle, act as “patient” capital and thus facilitate long-term strategies. Hence, the Big Three have the potential to cause significant change to the political economy of the United States, including through influencing important topics for corporations, such as short-termism versus long-termism, the (in)adequacy of management remuneration, and mergers and acquisitions. We reflected on a number of anti-competitive effects that come with the rise of passive asset management, which could have negative consequences for economic growth and even for economic equality. As well, we signaled how the continuing growth of ETFs and other passive index funds can create new financial risk, including increased investor herding and greater volatility in times of severe financial instabilities.”
Strategy 2: Active Management-Factor Funds
Objective: The objective of factor funds, or multi factor funds, is to capture specific factors that academic research has shown to beat the overall market over long measurement periods.
Factor investors, like index investors, are simply trying to own the market, while capturing the factor premiums that research shows come from some variation of the Five Factor Model, for example. This model was introduced by Eugene Fama, and Kenneth French. Their research demonstrated that stocks beat bonds (market factor), value stocks beat growth stocks (value factor), small cap stocks beat large cap stocks (Size factor), profitable companies beat non profitable companies (profitability factor), and positive investment characteristics beat those with negative investment characteristics (investment factor).
Therefore, they argued, that by tilting towards these factors of outperformance, we would stand a better chance at beating the market in a more efficient systematic manner. Dimensional Fund Advisors (DFA), is the largest provider of dedicated, research based, factor strategies.
They have been able to beat the market at a higher rate than traditional active management, not through security selection but rather factor tilting. Using these funds, however, requires a DFA financial advisor, which will mean an increase in cost to the investor. However, factor funds are now offered by many different providers, both in single factor and multi factor strategies.
Best For: Investors who are seeking a low cost, academically-based strategy to beat the market through the capture of factor premia. These funds are quite passive in nature but are categorized as active because of the factor tilting strategy, which does create tracking error, which at times can be significant depending on the specific factor targeting strategy utilized. This strategy is not advised for investors who are not comfortable with tracking error.
- While these funds are actively targeting specific factors, they are highly passive in nature.
- They can be purchased at a relatively low cost in mutual fund and ETF form.
- They provide exposure to specific factors which research demonstrates, may allow investors to outperform the market over the long run.
- If factors go out of favor for extended periods, investors could underperform the broad index.
- There is no telling that the future will look like the past, and thus targeting specific factors may become more challenging, or unreliable as markets, and economies change.
- Some of these strategies require a financial advisor, which may increase the overall cost to the investor, and meaningfully drag down net investment results.
In this first piece, I took a look at passive investment strategies both through the broad index fund as well as the factor fund lens. In Part II, I will explore various forms of active management, and what investors would benefit most from each. Taken together, these two pieces should be read together, and can serve as a guide to choosing the right investment strategy for you.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor. This article does not constitute tax advice. Every investor should consult their tax advisor or CPA before acting on any information contained herein.