The Part of the Active vs. Passive Debate That is Rarely Discussed
SUCCESSFUL MUTUAL FUNDS HAVE OUTPERFORMED THEIR TARGET INDEX “OVER TIME.”
THIS IS NORMALLY DUE TO SHORT PERIODS OF SUBSTANTIAL OUTPERFORMANCE, WHILE REMAINING PERIODS ARE EQUAL OR UNDERPERFORM THE INDEX.
TO PARTICIPATE IN THE OUTPERFORMANCE, YOU NEED TO ACTUALLY INVEST IN THE FUND DURING THOSE SHORT PERIODS OF TIME.
HUMAN NATURE AND THE TRADITIONAL PORTFOLIO BUILDING PROCESS MAKE #3 VERY DIFFICULT
I don’t think that it is a secret that I want to grow my clients’ accounts to be as large as possible. Reason number one is simple, larger account balances help my clients achieve their financial goals with a higher degree of certainty. Another truth, that has been discussed with each family, there is a financial incentive in it for me as well to increase the size of the accounts (my compensation is at least partially based on the size of those accounts). The investment options we select for each client carries a large impact on how large those accounts become over time. This has led to countless hours researching the available investment options, in a continual effort to improve expected outcomes. One of the bigger discussion points has always been when to go “Active vs. Passive.” Sifting through all of the noise of this debate, it comes down to one key point: If an adviser selects an active investment option for clients, he or she had better be willing to hold it for quite some time (otherwise the largest benefit of holding the fund over and index will be lost). See below:
Just Briefly – What Is Active Vs. Passive
What is Active vs. Passive? For those of you that already know, you can go to the next section. Here is a quick 30,000 foot view of the terminology. An “Active” fund is typically a mutual fund that is managed by a team within a certain set of pre-established parameters in order to hopefully beat a target index’s rate of return over time. Conversely, a “Passive” investment option (generally an ETF or an Index mutual fund) is an investment that mimics or very closely follows the target index’s entire portfolio.
There are, and will continue to be, arguments to be made for each side. For one, a passive investment typically has much lower costs (after all, you aren’t paying for anyone’s expertise, simply tracking an index). Active investments, if chosen correctly, should be able to beat the index’s rate of return over time. As with everything however, it doesn’t really work that cleanly. Index funds have grown in popularity over the years due to easier access, solid returns, and financial literacy. Active Funds have come under fire, as it is tougher to beat a passive option when volatility is low.
It is a continual discussion for many in our industry as well. If you log into Twitter right now, it is a high likelihood that someone in the #FinTwit community is currently having a semi-heated debate on active vs. passive right now!
When Active Beats Passive
Against the pressure of the rise in passive investing, fund companies like American Funds, Transamerica, and others have created compelling marketing pieces to show how their funds have beaten the S&P 500 over time. Two funds that have been used in the past by our firm, American Funds AMCAP R5 and Transamerica Capital Growth I, are highlighted below:
It is true, if you held these funds over the long haul, your account would be larger than simply investing in the index. And that is the entire goal of selecting an actively managed mutual fund, isn’t it? To beat the index over a period of time, which justifies the higher annual cost. However, the reality is, an active fund doesn’t beat the index 100% of the time, the averages are actually far less. In fact, if we dive deeper, there were really only 5 years since 2008 that American Funds AMCAP fund (R5 share class) “Beat” the S&P:
Transamerica (TFOIX) has done a little better, beating the index 6 times since 2008:
Here’s the one secret to using a fund to beat an index that is rarely discussed by either side of the argument. If a fund is only going to beat an index over certain periods of time, you need to actually hold the active investment during the good periods! Otherwise, you won’t participate in the above average performance, and you would have been better off simply owning the index the entire time. In the example above, if you didn’t hold the AMCAP fund in 2009, your performance relative to the index would be nearly identical. Easy solution, just hold the funds you select for forever and you will win, right?
Well, not exactly. For multiple reasons, investors don’t normally stick with investments through the tough times. For one, it is easy to look back at history and determine who the “good funds” were, hindsight is always 20/20. There are also a couple of other elements that make investing harder than it needs to be.
There is a compliance tagline in our industry that is used in almost every investment piece: “Past performance does not guarantee future results...” Yet when building portfolios, many advisers first look at how a fund has performed (year-to-date, over the last year, 3 years, etc.). If you are exclusively selecting based on recent results when building a portfolio, chances are the period of time where the fund will outperform the index has been missed. It is inefficient, and why many “fired fund managers outperform newly hired managers.” This concept has been written about many times, and one of my favorite blogs on it was written a while back by Josh Brown (The Reformed Broker).
Comparing returns with other options hurts, but human emotion doesn’t help investors either when it comes to sticking with a good fund. An example that has widely made the rounds is the Fidelity Magellan Fund vs. the S&P 500 from 1977-1990. Fidelity investments ran a study of the fund, run by famed portfolio manager Peter Lynch that found the following: “even though average annual returns of the fund itself were 29%, many investors lost money during that time.” Why? Investors bought and sold at the wrong times making emotional decisions after periods of strong or weak performance (buying more after strong performance, and selling after periods of negative returns). This is one of the best performing mutual funds in history, and investors continually got in their own way to harm their actual return. Humans aren’t built to have patience when it comes to these funds. Behavioral finance experts (a couple of my favorite are Daniel Crosby and Dan Ariely) have come a long way in helping us realize these biases, but I don’t think it will ever be completely possible to remove emotion from investing.
What Does All Of This Mean And What Does Our Firm Do?
In short, we use a combination of both active and passive funds for our client portfolios. Where we have strong conviction, and in places where the markets are not as efficient, we generally see some value in the additional cost of active options. Where we see little additional value in the additional cost of active management, we generally lean to a more passive approach. When it is all said and done, most of our portfolios being at fifty percent actively managed funds and 50% passive indexes, depending on risk might tilt 10% each way. When selecting managed funds we generally choose fund families with a proven history of choosing an investment process and sticking with it. Also, investors don’t look at how the returns were generated (allocation, selection, interaction, currency) and crosscheck that with the managers stated strategy. If they don’t generate outperformance for the reasons stated in their pitchbook then the success probably isn’t sustainable. Quite frankly, people get lucky sometimes. At Aurora Financial Strategies and Gettings Reed, we are hesitant to makes wholesale changes to our lineup based on recent performance, but will make a change if we can improve the portfolio (via cost, diversification, or conviction in other areas).
THE MAIN QUESTION I LEAVE FOR YOU IS THIS: IF YOU ARE GOING TO SELECT AN ACTIVELY MANAGED MUTUAL FUND, DO YOU HAVE THE CONVICTION TO HOLD IT THROUGH THE UPS AND DOWNS?
Thanks for reading,
Billy Cardwell is an adviser with Gettings Reed Financial Services. He can be reached at firstname.lastname@example.org or by calling (765)438-4682. Advisory Services are offered through Creative Financial Designs, Inc., A Registered Investment Advisor, and Securities are offered through cfd Investments, Inc, a Registered Broker/Dealer, Member FINRA & SIPC. Aurora Financial Strategies and Gettings Reed Financial Services are not Owned or Operated by the CFD companies