It’s still far too
early to gauge this year’s results, but the perennial active vs. passive debate
is well underway. When the final scores are posted early next year, advisors
may find that both those for and against may be right. From the passive side, advocates say it is
nearly impossible for a fund to continually outpace its benchmark index, and
that the effort isn’t worthwhile. Not only do active fund managers have to pick
the right blend of stocks or bonds, they must also compete against a benchmark
before the additional expenses of managing a fund. By contrast, proponents of actively managed
funds say passively managed funds by definition have no chance of beating the
index and will always lag their benchmarks by the amount of expenses and cash
drag.
Real-World Lesson. According
to market folklore, actively managed funds can underweight poor performers and
overweight outperformers in most market conditions, while their passively
managed counterparts must maintain their benchmark weightings, putting them at
a competitive disadvantage. Unfortunately for actively managed funds, the real
world is not so flexible.
Fund investors, after seeing their net worth plummet during
the 2008 financial crisis, began to turn to passively managed funds. Since the beginning of 2009, investors have
pumped some $1.145 trillion into passively managed equity funds and just $327
billion into actively managed equity funds. Meanwhile, they have seemingly
embraced actively managed fixed income funds over passively managed fixed
income funds, injecting $904 billion versus $389 billion over the six years.
How’re they doing
lately? After removing the outsized
returns of bear-oriented or leverage-focused short-bias funds, leveraged equity
funds, and leveraged fixed income funds, for 2014 passively managed equity
funds returned 4.07% on average, underperforming their actively managed
cousins, which returned 4.74%, by about 67 basis points (bps). That pattern
held at the three- and five-year marks, where actively managed equity funds
posted stronger returns than their passively managed brethren by 111 and 33
bps, respectively. At the ten-year mark,
passively managed equity funds, returning 6.96%, outpaced actively managed
funds by 34 basis points. Excluding the
short-biased and leveraged funds again, actively managed funds had a much
stronger track record of beating their stated benchmark than did passively
managed funds.
The major takeaway
from this example: When actively managed funds beat their stated benchmark,
they did so with much more magnitude than did their passive counterparts. But
as might be expected, when actively managed funds underperformed their stated
benchmark, their losses were also greater than their passive counterparts’
because there is greater volatility/risk in the actively managed group.
Padding the coffers. Over
the past six years, investors have padded the coffers of bond funds and
mixed-asset funds (target date and target risk funds), more than likely as a
response to the 2008 financial crisis and a need to diversify their portfolios
more. In the last years of the 1990s and the early part of the 2000s, investors
had been encouraged to use domestic large-cap funds as their primary holdings
for their core and satellite asset allocation process.
It’s not surprising that in 2004 the largest asset
allocation to open-end funds, other than money market funds (20.4%), was to
large-cap funds (17.5%). After the meltdown, as investors began reallocating
their portfolios, the obvious conclusion was to redeem from their largest
holdings (which performed horribly in 2008).
Best bets. In a 2009 report, Thomson Reuters chief index
strategist Andrew Clark highlighted that over the preceding 20 years, active
investors added incremental returns to their portfolios by using a combination
of actively and passively managed funds. The debate will continue between actively
managed and passively managed fund proponents. But the bottom line for clients
and advisors alike is their need to maximize returns while minimizing risk.
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