Arguement

The Active vs. Passive Debate Plays Out on MarketWatch

Arguement

Those of us who are old enough to have watched 60 Minutes in the 1970s will undoubtedly remember the Point/Counterpoint segment which featured liberal and conservative spokesmen debating hot button issues of the day. Even more unforgettable was the Saturday Night Live parody with Jane Curtin as the liberal and Dan Akroyd as the conservative. The financial information Website MarketWatch recently ran its own version of Point/Counterpoint on the topic of active vs. passive. Naturally, this piqued our curiosity.

Taking the active side was Rob Isbitts who feels that actively-managed funds are much maligned and should have a place in your retirement portfolio. Mr. Isbitts sets up a straw man of the “myth” that “90% of managers don’t beat the S&P 500 Index” based on what he has “typically heard”. Next, he goes on to say how his firm completed its own study using data from Morningstar Direct which allowed them to account for survivorship bias. They chose to compare the returns of four groups of funds to Vanguard’s S&P 500 Index fund:

1)    All mutual funds domiciled in the U.S.—funds of all asset classes

2)    All equity funds

3)    All large cap stock funds

4)    All large cap blend funds

As far as we are concerned, the only group that may be legitimately compared to the S&P 500 is the fourth group. The other three groups all include funds with vastly different risk profiles than the S&P 500. Even for the large blend group, we contend that it is appropriate to exclude funds that have less than 90% U.S. equities and to limit it to those funds where both the Morningstar category and the investment style are large blend. Thus, this study is of limited scope and would not be useful for drawing general conclusions about the performance of actively managed funds. They compared performance over six different time periods, only two of which were clearly stated by Isbitts (10 and 15 years ending 12/31/2013). The other four time periods were based on bull and bear market cycles, and although Isbitts stated that the dates were at the bottom of the article, we did not see them, but the article may have now been corrected. Nevertheless, we can infer the dates based on peaks and troughs of the S&P 500.

It is no surprise to us that their results did not support the “90%” claim. When they averaged all 24 combinations of time frame and peer group, the index fund beat about 60% of funds. The problem is that Isbitts (and other advocates of active) provide no definitive method for choosing the 40% in advance of their outperformance of the index. One consistent finding in their study was that during the two bull market periods, the index fund outperformed 80% and 63% of its peers, and during the two bear market periods, the index outperformed only 34% and 38% of the actively managed funds. Isbitts uses these results to repeat the tired old canard, “that active managers, in aggregate, are effective in curbing some of the losses in the worst of times.”

If an active fund experiences less of a drop in a bear market compared to its benchmark, the usual explanation is that the active fund had a cash position which mitigated the drop. However, it is this same cash position that can cause the active fund to lag its benchmark when the market rebound. Thus, to capture this benefit for the entire market cycle, an investor would have to switch from passive to active at the peak and switch back at the trough. Good luck with that! Lastly, the notion of superiority of active management in bear markets was demolished by S&P Dow Jones Indices in their year-end 2011 SPIVA Scorecard:

“Bear markets should generally favor active managers. Instead of being 100% invested in a market that is turning south, active managers would have the opportunity to move to cash, or seek more defensive positions. Unfortunately, that opportunity does not often translate to reality. In the two true bear markets the SPIVA Scorecard has tracked over the last decade, most active equity managers failed to beat their benchmarks.”

Taking the passive side was George Sisti. While we completely agree with his contention that the two primary components of active management—market-timing and stock picking—are modern day equivalents of alchemy, we believe that he could have brought forth more evidence to support his point. The only study he cited was Financial Literacy and Mutual Fund Investments: Who Buys Actively Managed Funds? which established a direct relationship between an investor’s degree of financial literacy and the likelihood that he would use index funds. Unfortunately, the authors also found that even the most sophisticated investors rely overwhelmingly on active funds, and the performance of funds chosen by financially literate investors performed no better than those chosen by less sophisticated investors. Furthermore, since the study was limited to German investors, it may lack relevance for American investors.

In our opinion, two studies that Sisti could have cited to more strongly support his point are Luck Versus Skill in the Cross-Section of Mutual Fund Returns and False Discoveries in Mutual Fund Performance Performance: Measuring Luck in Estimated Alphas. Both of these studies show that once we account for the outperformance (i.e., alpha) that we would expect to see from chance alone, the amount of true alpha remaining is statistically indistinguishable from zero. The chart below tells the story.

This particular iteration of the active vs. passive debate reveals how the ground has shifted from when the debate began about forty years ago. The debate is no longer simply active vs. passive, but active & passive vs. passive. Isbitts acknowledges this when he says, “The active-versus-passive debate should not be a debate at all. Both have merits.” Further evidence comes from the title of his firm’s study, “Active vs. Passive: Why They Both Win”.

As far as we are concerned, however, the debate is still on. We look forward to the day when the majority of investors heed the sage advice given by Mr. Sisti:

“Wealth accumulation is best accomplished by owning a prudent allocation of low-cost stock index funds for the long-term. Mix in some common sense, patience, and rebalancing. And please, stay far away from the active management Twilight Zone, where alchemists pursue illusions.”

We could not agree more.