The active versus passive debate is never-ending. Active managers assert that their stock picking can beat the market while passive managers contend that they deliver the greatest return over the long term by owning the market. Similar to opposing political parties, the two investment camps see the world in very different ways and argue their positions with passion. However, apart from the sound and fury, compelling performance statistics—such as those in the recently released S&P Indices Versus Active Funds (SPIVA) Scorecard—continue to underscore the prudence of a passive approach to investing.
Of course, over a full market cycle, we would expect a majority of active managers to underperform benchmarks. In fact, the SPIVA Scorecard found over the five-year market cycle from 2004 to 2008, the S&P 500 Index outperformed 71.9 percent of actively managed large-cap funds. In addition, the S&P MidCap 400 outperformed 79.1 percent of mid-cap funds, and S&P SmallCap 600 outperformed 85.5 percent of small-cap funds. What’s more, the Scorecard reports that these performance numbers are similar to those from the previous five-year cycle from 1999 to 2003.
Skeptics of the passive approach might respond, “All that may be true, but surely active manager must add alpha in a down market like we’re currently experiencing.” Wrong. In fact, the SPIVA Scorecard exposes the belief that bear markets favor active management as nothing more than a myth. In overwhelming evidence that supports the passive approach, the SPIVA Scorecard found that a majority of active funds in eight of the nine domestic equity style boxes were outperformed by indices in the negative markets of 2008. The bear market of 2000 to 2002 showed similar outcomes. You’ll find much more detailed information about the SPIVA Scorecard on the web.
I’d point out that the notion that active managers trounce passive managers in a downturn is founded on the faulty assumption that one can time the market, identifying the optimal time to get in or out of stocks. Rather, as passive investors who understand that markets move up and down beyond our control, we construct your portfolios of dissimilar asset classes to temper volatility. And we periodically rebalance to maintain your ideal asset allocation.
Also noteworthy, the SPIVA Scorecard found that benchmark indices outperformed a majority of actively managed fixed income funds in all categories over a five-year period. The five-year benchmark shortfall ranges from 2 to 3 percent per annum for municipal bond funds to 1 to 5 percent per annum for investment grade bond funds. Non-U.S. equity funds were similar, with indices outperforming a majority of actively managed non-U.S. equity funds over the past five years.
Reports like the SPIVA Scorecard continue to convince investors that the passive approach is more than an interesting academic theory. In fact, on June 22, The Wall Street Journal published an article, “Institutional Investors Distancing Themselves from Active Managers,” that detailed how managers of leading pension funds are turning their backs on active management in favor of lower cost passive alternatives. Among the managers interviewed was Bill Atwood, executive director of the Illinois State Board of Investment, who recently moved $400 million of the state’s $9 billion portfolio into index funds. Atwood was quoted as saying, “Active managers have not given us the added performance in a down market that we hoped for.”
According to the Journal article, Atwood is not alone. In fact, a recent survey by Greenwich Associates found that 20 percent of institutional investors recently moved assets from active into passive management, up from just 4 percent who had expected to make that shift last October. That’s a trend the Bank of New York Mellon expects will continue, forecasting that a record number of active asset managers will be replaced by index funds in the second half of this year.
Of course, you know I’m never one to run unquestioning along with the herd, but there’s a certain amount of satisfaction I get from watching some major institutional investors come around to our way of thinking. Today, the success of indexing cannot be viewed as an aberration, or a fad.
As Victor Hugo observed nearly 150 years ago, “One can resist the invasion of armies but not the invasion of ideas.” I’d add that it’s especially difficult to resist the wisdom of the passive approach to investing, because it has been proven time and time again that it delivers the superior long-term results upon which your secure retirement depends.