Dice Percentages

The Active vs. Passive Debate Plays Out in the L.A. Times

Dice Percentages

Over the weekend, this article by Tom Petruno caught our attention. Overall, we commend him for penning a good summary of the current status of the ongoing battle between active and passive for the minds (and wallets) of investors, but there are a few points with which we take issue.

A large part of the article deals with the study recently put out by the Capital Group Companies, the corporate parent of American funds defending its long-held practice of active management in the face of $263 billion of withdrawals since September 2008, according to Morningstar. We recently published our own article about it that appears to have struck a chord with them, as their spokesman said, “The firm’s track record isn’t luck.”

Even more interesting than that, however, is the assertion by John Rekenthaler, Vice President of Research at Morningstar, that they (American Funds) are the only managers who could talk about active management with authority. Really? The only ones out of literally thousands! If that is true (which it may well be), then active management has come to a very sad state indeed. Rekentheler also repeated the increasingly common complaint that the active vs. passive debate “has been a very one-way debate.” Considering that actively managed funds control $4.6 trillion of investor funds compared to $2.8 trillion for passive, it is hard to see it as one-sided in favor of passive. A few minutes of CNBC should convince even the most skeptical observer that the active voice is alive and kicking (and sometimes screaming). We do agree with Morningstar’s Director of Research, Don Phillips, when he says, “There are a lot of foolish index funds out there.” One that comes to mind is the PowerShares Lux Nanotech ETF, which has delivered a -10.6% annualized return for the five years ending 9/30/2013, compared to a 10.7% annualized return for the overall U.S. stock market, according to Morningstar.

Returning to the L.A. Times article, one recommendation that we would consider ill-advised is the following: “Consider active funds in asset categories where managers historically have had a better chance of outperforming the index.” The author cites emerging markets as an asset class where 43% of funds beat their index for the five years ending 6/30/2013, according to data supplied by Morningstar. However, when we look at the numbers from the Standard and Poors Index versus Active Funds Scorecard (SPIVA) which account for survivorship, we see only 25.5% rather than 43%.

 

 The case for going active in emerging markets is further weakened by the fact that over the last fifteen years (as of 9/30/2013), two of the funds in the top 5% of all emerging markets funds (according to Morningstar) have been DFEVX (DFA Emerging Markets Value) and DEMSX (DFA Emerging Markets Small Cap). Neither one of these funds makes any attempt to identify under-valued securities or to limit losses by holding cash in anticipation of a bear market. Instead, each fund buys all the securities that meet a set of criteria related to size and value and holds them until they no longer meet the criteria. The high returns captured by these funds have come as compensation for bearing not just the risks of emerging markets but the risks of small cap and value stocks as well. As we found in our own analysis of SPIVA, there really is no magical asset class where active is assured of beating passive. Among the four general asset classes, the numbers are as follows:

 

In answer to the proponents of active management who claim that it shines for mid-cap and small-cap stocks, the table below shows this not to be the case:

 

While the article does a service by mentioning the supreme importance of asset allocation, the author could have taken it a step further by discussing the importance of tilting towards compensated risk factors and how the “outperformance” of actively managed funds is often explained by nothing more than poor benchmarking. Overall, we think Mr. Petruno did a fine job in illuminating this complex topic, and we look forward to reading his future articles.