As political debates heat up around the country, I’m reminded that there is no more polarizing investment debate than whether active or passive management delivers better returns. To understand what the brouhaha is all about, let’s begin with some definitions.
Passive management is founded on the Efficient Market Hypothesis (EMH). Developed by Nobel Laureate Eugene Fama in 1965, EMH contends that securities will always trade at a fair value price that reflects all available market information. Therefore, if no security can be over- or under-valued at a given point in time, instead of trying to beat the market, passive managers simply own all the stocks or bonds in the same proportions as the index. Therefore, a large-cap passive fund, or an “index fund”, would own all 500 stocks in the S&P 500 Index. Because there is no research involved and the manager makes adjustments to the fund only to reflect changes in the index, trading costs are low. And the reduced trading of stocks and bonds can also increase the fund’s tax efficiency.
Conversely, active investors believe that markets are inefficient, or that fund managers can uncover unknown information that can lead to better returns versus an index. Accordingly, active managers invest in what they view as the most attractive securities, based on their own investment philosophy and market outlook. By evaluating everything from the state of the global economy to companies’ finances and new products, active managers believe they can identify investments that will beat the market, or the index that serves as a particular fund’s “benchmark.” Therefore, an actively managed large-cap equity fund might own 50 to 200 of what the manager believes to be the most attractive companies in the S&P 500 Index.
Of course, because research is required to identify the most desirable investments, costs are higher for active funds. Proponents of active investing argue that the extra costs are justified because of the potential for an active fund to outperform its benchmark.
What approach performs better? Semi-annually, S&P Dow Jones Indices LLC publishes an active/passive scorecard. According to the SPIVA U.S. Year-End 2015 Scorecard, 66.11% of all large-cap managers underperformed the S&P 500 benchmark during the past one-year period. Over the five- and 10-year investment horizons, 84.15% and 82.14% of large-cap managers failed to beat the benchmark. Also, 56.81% of all mid-cap managers failed to beat the S&P Mid-Cap 400® Index over the one-year period and 72.2% of active small-cap funds lagged the S&P Small-Cap 600® Index. Over five- and 10-year horizons, 76.69% and 87.61%, respectively, of actively managed mid-cap funds and 90.13% and 88.42%, respectively, of small-cap funds underperformed their respective benchmarks.
Clearly, recent SPIVA research suggests that active management at the individual stock level is not worth the additional costs for most asset classes. Given SPIVA’s report, it should be no surprise that in 2015 actively managed US-based mutual funds saw $207.3 billion in outflows (roughly $169 billion from equity funds) while passive US mutual funds took in $413.8 billion. Investors are coming around to the idea that it in their best interests to invest in asset classes (often via passive funds) rather than make bets on individual active funds or securities.
The Happy Middle Ground
Our approach with Dimensional Fund Advisors (DFA) marries some art with the SPIVA science. Although DFA’s philosophy has been characterized as “passive investment management,” the firm’s academic-based approach defies an absolute characterization as black or white. As you can see in table below, the firm’s philosophy is gray. If passive investing is also referred to as indexing, DFA has been value-weighted indexing.”
When we debate the merits of active and passive investing, it’s important to stress that beating the market should not be an investor’s only goal. Each one of us has personal investment goals that can best be achieved by investing in a properly diversified portfolio that is structured to respect the market’s efficiency and minimize costs. We diversify across numerous asset classes because, as The Callan Periodic Table of Investment Returns illustrates below, not only is it impossible to choose individual stocks and bonds that will outperform, but it is also impossible to choose outperforming asset classes.