April 11, 2012

The passive versus active fund management debate raged on recently as the most recent S&P Index Versus Active (SPIVA) report came out in March that stated that more than 84% of actively managed U.S. equity funds underperformed their S&P benchmark last year. Ignoring the obvious problem of using 1-year data to measure investment performance as well as the self-serving nature of the S&P report (licensing their indexes to index funds and ETFs is a big business for S&P), there are many arguments to be made for active investing when compared to most forms of passive, or index investing.

One of the key problems with a passively managed index fund is the cost, a shocking statement which is contrary to what many believe to be the benefit of index funds. If an index fund manages to successfully match its index or benchmark, which is not necessarily guaranteed as tracking errors often occur due to rebalancing efforts, there are still costs.

These costs may be significantly lower than actively managed funds, say .20-30% compared to 1.0% for actively managed funds, but it is still a cost. Which means when you invest in an index fund, you are going to underperform the index or benchmark this year, and next year and every year after that. Guaranteed. And that underperformance can compound over time. If your investment goal is to achieve the index or benchmark, you won’t achieve that goal – ever.

At least with actively managed funds, you have a fighting chance to beat the respective benchmark, which is a desirable goal for many long-term investors with patience, a long-term time horizon and the ability to refrain from chasing the fashionable trend or fund of the day.

That “fighting chance” of outperformance in actively managed funds is often achieved by outperformance in down markets. This may be a subtle endorsement for value-oriented investing, but preservation of capital should be a principal goal of actively managed funds and that often leads to outperformance in bear markets which can add alpha over a long-term time horizon.

How is this achieved? By careful stock selection which involves both buying stocks only at a discount to their intrinsic value, by apply a Margin of Safety to your selections, and picking quality companies not burdened by excessive leverage or a poor competitive situation. If the overall market takes a nasty downturn, active managers with a disciplined and prudent investment philosophy should be able to avoid the big mistakes that hurt long-term performance. An index fund holds the likes of Enron and Blockbuster, whether you like it or not, at least for some time frame.

The growth in index investing actually provides a nice benefit to actively managed funds, especially those with a value-oriented, research-driven style. In a recent paper, Lubos Pastor from the University of Chicago and Robert Stambaugh from the University of Pennsylvania say that a fund manager’s ability to outperform a passive benchmark decreases as the industry grows as more money chases opportunities to outperform passive benchmarks, and such opportunities become harder for managers to find.

Therefore the opposite must be true; if the industry shrinks, less competition among the remaining active managers makes it easier for them to find mispriced securities and outperform. Taking it to the extreme, if investors moved all of their investable assets to index funds, markets would probably be full of mispriced stocks.

With no active managers searching for mispriced assets, the first dollar invested actively would earn a high return by picking low-hanging fruit, inevitably leading investors back into actively managed funds. Their conclusion – the future performance of active managers is likely to be better than their past performance. Perhaps the growth of index funds and the recent outperformance relative to active management is simply one big cycle that is poised to turn as index investing continues to get bigger.

Another way this growth of indexing itself creates opportunities for actively managed funds is through the rebalancing efforts of index funds. These funds that track popular indexes such as the S&P 500 and Russell 2000 tend to rebalance at index reconstitution dates so as to minimize tracking error. The rebalancing of the indexes by Russell or S&P on a frequent basis often provides irrational selling or buying.

When a stock is dropped by an index, billions of dollars of index funds must drop the stock as well, which leads to short-term price drops on or near the re-balancing date. If the company in question is a quality company with no glaring fundamental problems related to the sell-off, this is almost free money to investors as an astute and patient fund manager can pick up great stocks at a 10-15% discount, dare I say risk-free. The flip side can also occur as a new stock enters the index, it often experiences a short-term pop providing a timely exit for a stock that may have been approaching fair valuation or over-valuation.

There are many reasons to own index funds as well as reasons to own actively managed funds and a diversified portfolio should hold both based on your investment goals and personal financial situation.

But I believe the best reason to own actively managed funds is that these managers still give their best efforts to prudently act as caretakers to your investment. Beating a benchmark or index should not even be a goal for most long-term investors. Many good fund managers explicitly state that their goal is long-term capital appreciation in the form of positive absolute returns over time along with preservation of capital as an important, if not the overriding objective.

With index investing, no one is watching out for you, just a computer, and therefore the investor gets the whole kitchen sink. There is no one at an index fund trying to help you avoid major investing pitfalls. It’s almost as if they’ve just given up.