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Passive vs. Active: End of Debate?

Last October, we weighed the merits of combining both active and passive strategies in our asset allocation recommendations.  Subsequently, the fund research firm Lipper estimated that in 2014, only 15% of active large cap equity managers outperformed the S&P 500. Such poor relative performance would seem to settle the debate in favor of passive investing. Or does it?

First, we acknowledge having a dog in this fight, which may cloud our judgment: Bristlecone manages a large cap portfolio, and it lagged the return of the S&P 500 index last year.

At the same time, since some of our principals have been through a few investing cycles in the past 25 years, we can’t help but have a sense of déjà vu when reading headlines about the death of active investing. As one can see from the chart below, it is objectively hard to see a trend in the data that supports the conclusion that the debate is settled.


As is often the case in investing, extrapolating recent short-term trends can be hazardous to your wealth. Clearly, 2014 was a very challenging year for active US equity managers, but the prior year saw 62% of funds beating the S&P 500, according to Morningstar.  Since 1989, the proportion has fluctuated between the mid-teens and the low eighties. Over the long-term (periods greater than 10 years), less than half of equity managers will beat the S&P 500. This can be explained mostly by two factors: higher cost and higher cash. By definition, an index does not bear any expenses and does not hold any cash. Actively managed funds incur management fees and trading costs, and always have at least a small allocation to cash.

Over shorter periods of time (3 to 7 years), one can see from the chart above that there can be some persistent underperformance or outperformance from active managers. Studies, as well as our own experience, indicate that these cycles have more to do with the relative performance of different asset classes, or industry sectors within the index, than the actual skills or lack thereof from active managers.

Because a significant proportion of equity managers do not mimic the S&P 500 in selecting portfolio holdings, our experience is that they will tend to outperform this widely used benchmark during periods when any combination of the following occurs:

  • Small cap stocks outperform large cap stocks – active managers tend to hold a greater proportion of smaller companies than found in the S&P 500;
  • International stocks outperform US stocks – active managers tend to hold foreign stocks that are not part of the S&P 500;
  • Performance of the index is broad based rather than concentrated in fewer industries or larger companies – the S&P500 performance can be largely driven at times by one industry (e.g. technology) or one very large company (e.g. Apple) that is not as widely owned by active managers;
  • Cash outperforms equities (i.e. during bear markets) for the reasons previously discussed;

Conversely, active managers are more likely to underperform when these factors are reversed, which, with the exception of cash, was the case in 2014.

What’s an investor to do?
As we discussed last October, we believe that passive investing does have merit. But we are also confident that active management can add value over the long-term. Whether one agrees or not, we hope to have demonstrated that not letting short-term trends dictate one’s investment process is critical. As we’ve said before when commenting on other popular investing ideas making headlines, if you’re going to change your mind about the benefits of passive vs. active, growth vs. value, large vs. small, US vs. international, stocks vs. bonds, etc. , it is better to time it when the investment category that you’re considering getting rid of is outperforming, not underperforming. This contrarian discipline is key to our asset allocation process and will remain so in years to come.

There’s More to Estate Planning than Just the Will
“Wills, health care directives, list of passwords (…) the information family and friends will need when a loved one dies goes far beyond those much-talked-about documents”  This column from the NY Times points out some common blind spots in estate planning.

On a lighter subject, we couldn’t help but smile when stumbling upon this article in the New Yorker: Ayn Rand Reviews Children’s Movies.

Finally, if you could spend one minute of your time on this very short survey to help us improve this newsletter, we would appreciate it. You can also call us with ideas or comments.