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passive strategies

Our previous article discussed how investors have gotten too caught up in the debate over active versus passive strategies while not focusing enough on the main driver of portfolio returns; asset allocation. While we view the active versus passive decision as a secondary one, it is a decision that impacts results. Therefore, we wanted to share our thoughts on the topic.

We believe passive strategies, actively managed funds, and individual stocks and bonds all fulfill important roles in diversified portfolios. While we do periodically utilize passive funds, we view recent commentary as too biased against active strategies and think it’s important to balance out the conversation.

Passive funds certainly do bring several desirable attributes to the table, but they are not a no-lose proposition. Low costs and eliminating the risks of meaningfully underperforming an index top the list of advantages. In fact, those are precisely the characteristics we look for in certain segments of portfolios.

However, when it comes to investing there’s no “silver bullet” solution. We also see numerous drawbacks associated with passive funds. And these drawbacks don’t always receive enough attention in our view.

One obvious example is that since passive funds can’t measurably underperform an index, they can’t outperform it either. We don’t believe that investors should willfully surrender their potential to outperform markets with the entirety of their investment assets.

Also, investors need to understand and be comfortable with the fact that there is absolutely no fundamental research or analytical decision-making driving investment actions within passive funds. There are no considerations given to the viability of a company’s business model, the strength of their management teams, their operating history, or overall business fundamentals. Passive funds also turn a blind eye to valuations or the process of attempting to determine if a security is worth what investors are currently paying for it. Both factors can add risk to passive investment options that are often overlooked.

For example, securities held within passive funds are purchased solely based on their weighting within a specific index, with greater amounts of capital allocated to the largest (and often most pricey) components of the index and less capital directed to the smaller and often neglected components. That is the exact opposite approach from the classic buy low, sell high mantra. While this practice may be working well in the current market environment, investors might want to think about how this strategy would have fared in other market conditions. Think back to the runup to the “tech bubble”. Investors would have ended up continuously adding more and more exposure to technology stocks as they screamed higher and comprised larger weightings within major indices. As we know in hindsight, the result of this approach was not pretty.

Investors favoring passive funds argue that the average active manager has not been able to outperform their passive benchmark recently and therefore the higher fee structure associated with active funds is not justified. While we don’t dispute the fact that the ‘average’ active manager has underperformed recently, we do question if focusing on averages is the proper metric to utilize to form a proper conclusion.

Warren Buffett is an active manager and his track record provides an illustration of why investors should rethink the conclusion that their outperformance potential has no value. A $10,000 investment in the S&P 500 in December of 1987 would have grown to an impressive $179,475 by September of 2016. However, during the same period, that $10,000 investment into Buffett’s Berkshire Hathaway stock would have grown to a staggering $745,584.

Maybe it’s unfair to use the track record of one of the most successful investors in history to defend active managers as a group. But it’s also unfair to conclude that active management doesn’t work because the ‘average’ active manager hasn’t outpaced their benchmarks recently. Why should averages matter? Who strives to be average? Investors certainly aren’t restricted to only investing their assets with average active managers.

We’re quick to highlight that large proportions of active funds have unreasonable costs or come with brokers’ sales commissions. These products are often sold to investors by salespeople with profit motives or are the only options in captive situations like 401ks or annuities. Including performance results from these inferior strategies skews the averages for active managers as a group. The first step in our fund selection process is to eliminate these poor options from contention. Once the herd is thinned, the case for high-quality active funds strengthens dramatically because comparative fund performance relative to benchmarks notably improves.

Engrained in our support for active management is a rigorous fund selection process. We look for numerous features when selecting active strategies for client portfolios. Fees must be reasonable and justified by long histories of outperformance. We won’t pay active management costs for funds that mimic indices.

Active managers can only outperform an index by deviating from it and the size of their allocation decisions matter too. A strong risk management process is also important. Active managers have tended to outperform passive strategies in declining markets by losing less. Investors may be underappreciating this point since equity markets have experienced a few measurable setbacks since the financial crisis.

A disciplined selection process significantly increases investors’ prospects for choosing active managers that will be able to outpace index returns. After the selection process, investors should frequently monitor their fund managers’ performance in comparison to the fund’s benchmark as well as against the peer group of funds within the same category. This isn’t a “set it and forget it” process. Oversight is required, and changes are sometimes necessary.

Diversification is one of the most important components of efficient portfolio management. Spreading exposures across various asset classes reduces the overall portfolio risk and volatility. We believe that diversifying across active and passive strategies is just as prudent. Both strategies have a place in portfolios. And neither should be judged based on isolated data points but on the holistic picture and the benefits versus drawbacks associated with each specific strategy.

Warren Buffett certainly isn’t the only wildly successful active manager. Many more have added tremendous value in the form of excess returns for their investors. This point may be easily missed if the focus is on average results or if investors indiscriminately accept unbalanced commentary that passive strategies are the optimal solution. However, once a stringent investment process is incorporated to eliminate subpar options and identify top-tier active strategies, the data changes significantly. Without such a process, investors may be relegated to accepting mediocre active managers or settling for index returns. Not us. We believe outperformance is extremely valuable and very achievable.

Published January 2018

To read the companion piece to this article, click here.

About the Author: Daniel Eye, a Chartered Financial Analyst® Charterholder, serves the firm as the Chief Financial Officer and Investment Committee lead for Roof Advisory Group. Roof Advisory Group, Inc., an independent investment management and financial advisory firm based in Harrisburg. 

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