Active and Passive Money Management

In recent years, investors have been ditching those active managers in favor of ETFs and other index funds, which typically offer a way to get market exposure at lower fees. The trend continues. The late John Bogle, the inventor of the index fund, states:

“One development could mitigate much of the advantage that index funds enjoy and slow the rush to own them, but you’re probably not going to like it. When the market suffers a prolonged decline, active managers can gain an edge over indexers by moving large portions of assets into cash or into defensive sectors such as utilities and consumer staples. Shareholders of index funds could then suffer more than owners of actively managed funds, and they could take their losses harder due to the perceived security they feel precisely because they merely own the market and aren’t trying to beat it. That might make active investors feel a bit of schadenfreude for indexers who have been free-riding at their expense, but the feeling probably wouldn’t last. The greater price swings that could ensue in a heavily indexed, less-active market are likely to exacerbate losses for everyone. Until the next bear market, the indexing trend is likely to accelerate. As with any tragedy of the commons, indexing is the sensible thing for each individual to do, but each individual should remember that many sensible ideas, especially in investing, make less sense as more people put them into practice. When the stock market turns down again, index fund owners will have to become their own active manager and make sure they’re well diversified, with limited exposure to risk, chaos, and catastrophe.”

We use both active and passive investments at Equitas. One of the benefits to the growing trend towards passive investing is lower fees to the investor. Not only do the passive ETFs generally charge lower fees, but the competition is driving fees lower among active managers. Sophisticated investors should seek active managers in asset classes with low efficiency and high dispersion, and look to passive investing in the most efficient asset classes.

Below is some research from the Equitas analysts on the cyclicality of active and passive investing. These are the net annualized return numbers for the last 20 years for the Standard and Poor’s S&P 500 ETF, the Vanguard S&P 500 Index Fund, the actual S&P Index, and the entire Morningstar Universe of all domestic stock managers shown annualized over rolling periods and year by year from 1998 to 2017. Remember, unlike test grading in school, a money manager universe ranking lists 1 as the best and 100 as the worst.