Business

The Stampede From Active Management To Passive Investments

FORECASTS & TRENDS E-LETTER

by Gary D. Halbert

December 6, 2016

  1. The Rationale for “Active” Investing
  2. The Rationale for “Passive” Investing
  3. What You Really Need to Know About Active vs. Passive
  4. Takeaways From Today’s Active vs. Passive Discussion
  5. Halbert Wealth Management’s “Alpha Advantage Strategy”

Overview

Over the last decade, we have seen a massive shift on the part of investors away from so-called “actively-managed” mutual funds and exchange-traded funds (ETFs) and into so-called “passively-managed” funds – also referred to as “index” funds.

Over the three years ended August 31 alone, investors added nearly $400 billion to passive mutual funds and ETFs while draining more than $400 billion from active funds, according to data from Morningstar, Inc. That’s huge!

Active Management Passive Investments

Active Management

While the majority of mutual funds continues to be of the active-management style, that is rapidly changing. The question is whether the stampede from actively-managed to passively-managed funds is a good thing or not.

The Rationale for “Active” Investing

Actively-managed funds have a designated manager (usually a management team) that makes the day-to-day decisions on which stocks to own. The frequency of trading varies widely. The goal of active management is to equal or beat a particular benchmark (such as the S&P 500 Index or others).

Active managers believe that the markets are inefficient, and as such, anomalies and irregularities in the capital markets can be exploited by those with skill and insight. Prices react to information slowly enough to allow skillful investors to systematically outperform the market, they believe.

Analyzing market trends, the economy, company-specific factors, etc., active managers are constantly searching out information and gathering insights to help them make their investment decisions. Many have their own complex stock selection and trading systems to implement their investment ideas, all with the ultimate goal of outperforming the market.

Active management strategies vary widely from manager to manager. These strategies can include fundamental analysis, technical analysis, quantitative analysis and macroeconomic analysis, just to name a few. Active managers may, or may not, be fully-invested at all times. Some of the assets may be parked in cash (money market fund) from time to time.

The Rationale for “Passive” Investing

Passive management, or “indexing,” is an investment approach based on investing in exactly the same securities, and in the same proportions, as an index such as the Dow Jones Industrial Average, the S&P 500 or others.

It is called “passive” because the fund managers don’t make decisions about which securities to buy and sell; the managers merely construct their portfolios to be as identical as possible to the index they are tracking.  The managers’ goal is to replicate the performance of an index as closely as possible.

Passive investors believe that market prices are generally fair and quickly reflect all the relevant information available. They also believe that consistently outperforming the market for the professional and small investor alike is difficult, if not impossible. Therefore, passive managers do not try to beat the market, but only to match its performance.

Passively-managed funds, almost by definition, have lower fees and expenses than their actively-managed brethren. It is also important to know that passively-managed funds are usually fully invested at all times. If the stock market goes down, passive funds lose just as much as the market, or more due to fees and expenses.

Remember that the S&P 500 Index lost over 50% in 2007-2009, and most passive funds experienced similar losses. Keep in mind that it takes a 100% gain to recover from a 50% loss. That can take years!

What You Really Need to Know About Active vs. Passive

A debate about the two approaches has been ongoing since the early 1970s. I will tell you that there is no “pat” answer to this question, although I will explain my own preference as we go along today.

Each side can make a strong logical case to support their arguments, although in many cases, the support is due to different belief systems, much like opposing political parties. However, each approach has advantages and disadvantages that should be considered.

The goal of active managers is 1) to meet or exceed their benchmark index, and 2) to lose less than the market during down-trending periods. Keep that in mind as we proceed.

As for active management, the most important thing you need to know is that the vast majority of active managers have under-performed their benchmark indexes in recent years. Depending on whose numbers you read, some 60% to 66% of active managers have failed to match or exceed their benchmarks the last several years.

Their primary excuse is that the stock market has skyrocketed in recent years, and active management strategies shouldn’t be expected to keep up in such an unusual environment. Really? Are you buying that? I didn’t think so.

Just as important, many active managers experienced their worst losses in their histories during the severe bear market in late 2007-early 2009. The idea that active managers can get you out of the market, or at least minimize losses, blew-up big-time for many in 2008. Some lost almost or just as much as the S&P 500, which as you know was down over 50%.

Active Management Passive Investments

Here is what you should take away from this discussion on active managers. While 60-66% of active managers have failed to meet or exceed their benchmarks in recent years, that leaves over one-third that did. The question is, how do YOU find the successful active managers?

Unfortunately, most investors don’t have access to (or are unwilling to pay for) sophisticated services that track and rank active managers. Many of the most successful active managers don’t advertise widely (they don’t need to), so you’re not likely to hear about them. The average investor’s odds of finding the truly successful active managers are sadly quite low.

Now let’s turn to the most important thing you should understand about passive strategies. As I noted earlier, most passive managers are at or near 100% invested at all times. What this means is that in a market downturn, passive investors are going to experience the whole loss or maybe even more due to fees and expenses.

Put differently, this means that the millions of investors who have herded into passive strategies over the last few years will very likely regret that decision in the next serious downward correction or bear market. Unfortunately, when investors move en masse, it is very often the wrong decision. Think “contrary opinion” theory.

Takeaways From Today’s Active vs. Passive Discussion

The fact is, there are plenty of successful active managers and funds out there. Unfortunately, there are probably twice as many that are mediocre or worse. The question is, do you have the tools to separate the good ones from the bad ones? The answer for most investors is NO.

As an aside, this is exactly the reason I started Halbert Wealth Management in 1995 to help investors identify the successful active managers. Over the last 21 years, we have invested in the expensive ranking services and the sophisticated tools necessary to identify the successful managers and weed-out the under-performers.

The bottom line is, if one can consistently identify the successful active managers, as we believe we can, then there is no question that I would recommend actively-managed strategies over passively-managed strategies.

I’ll take my chances with successful active managers over passive managers that are sure to get clobbered in the next serious downward correction or bear market. The current stampede into passive investments is a mistake in my opinion.

Putting Together Combinations of Active Managers

Even the best active managers will hit a “rough patch” now and then when their investment strategy gets out of sync with the market. For that reason (and others), we always recommend that clients diversify with multiple managers. We assist clients in determining the combination of managers that best suits their financial goals and risk tolerance.

Many of our clients prefer actively-managed strategies that can invest LONG OR SHORT with the potential to profit from a rising or falling stock market. In 2013, we analyzed the universe of active managers that trade long and short, which led to the introduction of our…

ALPHA ADVANTAGE STRATEGY

The Alpha Advantage Strategy is a combination of professional active managers who trade both long and short (as market conditions warrant). Each of these managers today has at least a decade of actual trading of their proprietary systems.

The beauty of the Alpha Advantage Strategy is that you can access this combination of successful active managers in one account at one custodian (Guggenheim) for a minimum of $50,000. You instantly have a level of diversification with multiple successful long/short strategies.

So how has it done, you ask?

As of the end of October, Alpha Advantage gained an actual 16.81% in 2016 net of fees and expenses. It was up again in November, but we don’t have final numbers yet. Over the history of this particular combination of managers, dating back over a decade, Alpha Advantage would have gained 18.4% annualized on average net of fees and expenses.

Hypothetical Performance August 2005 – January 2014

Actual Performance February 2014 – October 2016

Active Management Passive Investments

The hypothetical portion of the returns shown above is simply the combined historical actual performance of each one of the strategies that make up this portfolio, net of all fees and expenses. As you can see, the numbers are very attractive! 

While there are no guarantees that this combination of managers will always be this successful, their past track record is very impressive.

Best of all, Alpha Advantage would have had less risk, as measured by drawdown. The S&P 500 had a worst drawdown of over 50% during this time period. Alpha Advantage’s worst drawdown would have been only -16.8%.

And here’s the most surprising part: Alpha Advantage not only would have made money in 2008, it was the best year in the program’s hypothetical track record. And who isn’t looking for a strategy that actually would have made money in 2008 when everything else got clobbered?

As always, I must remind you that past performance is not necessarily indicative of future results. Also, the performance illustrated above must be considered hypothetical until January 2014 because, to our knowledge, no one had money invested with this specific combination of strategies during the time period shown.

Action To Take: At this point, I must assume you agree with me that carefully selected active management strategies are preferable to passive index investing, which will get clobbered in the next bear market. If so, I encourage you to take a CLOSER LOOK at our Alpha Advantage Strategy.

Call us today at 800-348-3601 with any questions, or if you would like more information, including the application and forms to open your account at Guggenheim in this exciting multi-manager program.

Wishing you profits,

Gary D. Halbert