November 27, 2017
As investment professionals, we are very mindful of the expenses paid for holding particular investments. In recent years regulators, academics, and the media have heralded the advantages of keeping investment costs low through passive, index-based investing. Active management, which compensates a team to select securities, has been criticized. The evidence is pretty compelling. Over recent years few active managers have beaten the market after fees.
S&P Indices publishes a scorecard comparing active manager returns versus their benchmarks. Through June 2017, 83% of large cap US equity active managers underperformed the five year returns of the S&P 500 index after fees. Strong recent equity returns may have played some part in this underperformance since there is evidence to suggest that active management does better in bear markets. Part of active management’s strength in bear markets stems from managers holding cash in their portfolios, which provides some insulation from a downturn. More importantly, active managers can deviate from market weightings, opting to own less of the market’s recent winners, or none at all. If enthusiasm for those “winners” wanes, and their share prices slide, the managers’ holdings in other parts of the market may prove less sensitive to retreating returns.
Our firm has supported the use of some low-cost, passive investment vehicles for exposure to certain market segments such as large US Cap. The simple fact is that active managers have to produce higher before-fee returns in order to justify their higher fees. Any fee drag from underperforming active managers can have wealth-reducing consequences. However index based investors need to recognize that during challenging market stretches the indices will simply follow the market down. Over the long term this should be of little consequence provided that the investor is prepared to follow their strategic plan, and not succumb to the emotions which can lead to selling when prices are low.
The average American investor is of course a person with human behaviors and tendencies. Social science research shows that centuries of survival experience have wired humans to weigh losses more heavily than gains. Instincts kick in when perceived threats arise, making corrective action feel like the only acceptable option. When the market-tracking indices begin to fall, at what point will the fear reflex of a given investor cause him or her to sell, and will this point be near the market bottom? When markets turn down, it takes fortitude to follow the instinct-defying advice of Warren Buffett: “Don’t do something, just sit there.”
Retirement plans and robotic investment services have increasingly emphasized passive investing. This has made sense during times when returns are high. Moreover the visible risk is currently low, as evidenced by a recent WSJ observation that 67 consecutive days had passed without a 1% up or down move in the Dow. However we cannot help but be concerned that there are a lot of index holding investors out there who do not have a long term strategy to provide a bulwark against rash decisions during a market sell off. Whenever it arrives, the next major downturn will test how well the average investor can resist cutting their index based equity exposure at the worst possible time.