Cameron Hinds, CFA, Great Lakes
Sean McCarthy, CFA, Southwest
Marc Doss, CFA, California, Nevada
Michael Serio, CFA, Mt. Northwest
David Roda, CFA, Southeast
William Keller, CFA, Mid Atlantic
Kei Sasaki, CFA, Northeast

In this Monthly Market Advisor:

• There continues to be debate about which strategy is better: active investing or passive investing. It’s important to understand the difference between the two.
• The question being debated centers on active strategies’ underperformance versus passive strategies in recent years. Passive strategies have done well for so long that some may be surprised to hear that there have been long periods of strong active management.
• For many investors, using both active and passive strategies is appropriate. For investors to meet their appropriate return targets, it may be beneficial to work with an investment professional to help create appropriate long-term asset allocation structures.

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There continues to be debate about which strategy is better: active investing or passive investing. Before going further, it’s important to understand the difference between the two:

• Active investing aims to profit from the skills of an investment manager who strives to earn greater returns than market indexes. It involves substantial research and possibly a fair amount of trading. These activities raise the cost of investing, meaning the manager has to beat the market by a margin sufficient to cover the higher costs.
• Passive, or index-based, investing seeks to earn the average return of a segment. A passively managed fund’s goal might be, for example, to track the S&P 500 Index’s performance. Classic indexing means constructing a portfolio with the same market capitalization mix as exists in the marketplace.
  

A Closer Look at Active Strategies’ Underperformance

The question being debated centers on active strategies’ underperformance versus passive strategies in recent years. In fact, passive strategies have done well for so long that some may be surprised to hear that historically there have been long periods of strong active management.

This cycle of active strategy underperformance has been tied largely to the current bull market. The past eight years have seen consistent monetary stimulus (low interest rates), little volatility, and a lack of the corrections typically seen in a bull market. With the exception of the past year, equity correlations have been high and dispersion has been low—not an environment where one would expect active strategies to flourish.

Yet, the reasons for the underperformance, especially in regard to large-capitalization (cap) stocks, may be simpler. Chart 1 shows the vast majority of active strategies’ underperformance in these stocks is due to three factors:

• Fees
• Holdings of cash
• Holdings of non-U.S. stocks

The holdings of small- and mid-cap stocks have very modestly helped performance over the past five years. As short-term interest rates continue to increase, the drag of cash in an all-out bull market may be lessened, assuming we ultimately experience both more market volatility and typical corrections. In addition, the underperformance of international stocks may not be as pervasive in the future; in fact, it may even become a positive. The question to consider today is whether the next five to seven years will be different than the last five to seven and what implications will that have. Over this time period, it would not be surprising to see the emergence of an economic recession, market corrections, and increased volatility. This clearly would not be the same investment environment we’ve since 2009.

Chart 1.

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Source: Strategic Insight Simfund, Bloomberg L.P., Investment Company Institute, Empirical Research Partners Analysis., 6/16 Reprinted with permission.

¹ The asset-weighted numbers: (116) basis points - 5 years, (105) basis points - 10 years and (101) - 15 years.

Passive Strategies’ Performance

Even if one assumes active management will continue to underperform, the manner in which an investor applies exchange-traded funds (ETFs)—a popular passive investing vehicle—in a portfolio is crucial. Some investors may choose to use ETFs and go it alone without any professional advice. However, charts on the next page would argue with this practice.

Evidence is emerging that the typical investor does not obtain returns that are produced by the ETF’s. One of the more popular “smart beta” strategies the past few years has been low-volatility ETFs. The idea is to take less risk (volatility) in an individual stock portfolio yet actually outperform the indexes (in this case the S&P 500). As can be seen in chart 2—that has been the result over the past six to seven years. The published “buy and hold” performance has been quite good for this ETF strategy. However, the dollar-weighted performance (which accounts for the timing of when funds actually flow into an ETF) indicates the average investor’s performance has been around 1.75 percent less than the ETF itself. This is strong evidence of investors buying the strategy after it has gone up and selling during points of weakness. To avoid these emotional investment mistakes, it may be beneficial to work with an investment professional to help with positioning of passive strategies.

Chart 2.

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Source: Strategic Insight Simfund, Empirical Research Partners Analysis, 9/2017. Reprinted with permission.

¹ Includes iShares Edge MSCI Minimum Volatility USA ETF (USMV), PowerShares S&P 500 Low Volatility ETF (SPLV), and POWERSHARES S&P 500 High Dividend Low Volatility ETF (SPHD).
² Money-weighted returns approximate the return realized by actual investors based on the timing of their allocations and withdrawals. Calculation assumes all inflows or outflows occur in the middle of each quarter.

In addition, based on the flow of assets into ETFs over the prior three months, the resulting one-year performance was inversely related to the actual performance. In other words (as shown in chart 3), the ETFs that had the strongest flow of new money going into the strategy tended to underperform—very significantly—the ETFs that were not popular and actually losing assets.

Finally, investing in traditional cap-weighted indexes is generally a view that larger-cap stocks can outperform the smaller-cap stocks within the index. This thinking may be fine if the investor has confidence that the big will get even bigger on a relative basis. However, it is somewhat of a “buy high” strategy.

Chart 3.

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Source: FactSet Research Systems, Empirical Research Partners Analysis, 11/17. Reprinted with permission.

¹ Net new money flows are based on the net flows in the prior three months.

Conclusion

Obviously, this type of activity is unlikely to produce the best investment results. The bottom line is that, rather than going it alone, investors who want to employ passive investing strategies may be better off by turning to an experienced investment professional, who has the tools to create a prudent long-term investment plan that helps avoid emotional investment mistakes.

In conclusion, consider these interesting points from the information above:

• For many investors, using both active and passive strategies is appropriate.
• While many investors believe the primary reason active equity strategies have underperformed passive strategies is higher fees and poor stock selection, in reality the relative underperformance has more to do with the unique investment environment of the past eight years.
• There is emerging evidence that the average investor is obtaining performance in ETFs that is surprisingly disappointing. Investors tend to make emotional decisions in positioning ETF strategies—as they have historically in mutual funds. In other words, even if investors believe in the passive investing concept, to meet their appropriate return targets, they may still need a professional advisor to create appropriate long-term asset allocation structures and avoid emotional investment decisions (buying high and selling low).