Active vs Passive 101
A common debate amongst investment professionals relates to “active vs. passive” management styles within mutual fund and exchange traded fund selection. One of the common arguments from those favoring an “active” strategy is that active managers can find and add value during market volatility or market downturns. The advantages of passive management strategies outweigh the cost and risks associated with active managers.
Given that 2020 has been filled with uncertainty, unique opportunities/risks, and a 30% equity downturn, we wanted to revisit and review the recent results to see if active management added value to client portfolios. Active managed strategies focus on the belief that mutual fund (or ETF) managers can provide value to investors by outperforming their target benchmark. Said differently, a manager may believe they can outperform the S&P 500 by selecting stocks intended to provide a higher rate of return compared to the index, after fees. The core belief of active management is that the manager possesses a unique skill at stock selection, can predict long-term outcomes, and can add more value than indexing through their process. Passive management focuses on the belief that capital markets are efficient and therefore it is impossible to have information that allows a manager to outperform the market index. Said differently, a passive management strategy would replicate the S&P 500 Index, owning essentially the exact securities comprising the index, and accepting the market rate of return. The core belief of passive management is that the ability to outperform an index, after fees, is impossible. The managers that do outperform do so with luck that is not proven to be replicated over time, or they did so with more risk. TruNorth Capital focuses on the long-term benefits of a passive management strategy predominantly based on consistent evidence that active managers cannot consistently outperform benchmarks after fees. A study at the core of our belief is the “S&P Indices versus Active” scorecard study, known as SPIVA. The SPIVA studies both short-term and long-term of managers relative to their indexes. The ongoing study also looks for “persistence” of outperformance over long periods of time. For example, if an active manager outperforms their index in the first quarter, were they able to continue that outperformance over a long period of time. The SPIVA completed a review of the 2020 market events and the results continue to support the benefits and our belief in passive management: SPIVA Executive Summary – Full study is available here.
Despite 2020 being a time when active managers indicate that they can add value, most active managers underperform relative indexes. Of domestic equity funds, 64% underperformed the S&P Composite 1500® in the first four months of 2020, and 67% underperformed in the past two quarters. During the one-year period ending March 2020, 72% of domestic equity funds underperformed, slightly worse than the year-end 2019 result (70%).
Those managers that did outperform their index during this time still show meaningful long-term underperformance relative to their benchmark. Even those managers that had a good start to 2020 still are underperforming over longer periods of time.
The underperformance is widespread amongst asset classes, not just domestic large companies, which is often a focus of literature and studies.
When you consider the internal expenses, manager risk, consistent evidence of underperformance and tax inefficiencies of active management our goal of building diversified portfolios using passive investment strategies continues to be supported. The data is even worse after you include the industry average 1% fee of most wealth managers. Investment costs, including fund fees, trading costs, and wealth advisory fees, have a very high probability of leading to investment underperformance that over time can significantly impact financial asset growth and retirement. In these market conditions, we believe that if active management could add value to a portfolio management strategy, the results of the SPIVA research should have supported widespread outperformance of active managers relative to their benchmarks. Instead, the results continue to support the performance benefits of passive management. If you’d like to discuss our approach in greater details, please email us, or schedule directly using the scheduling link – Just click here to schedule.