Why “Either/Or” Is The Wrong Approach To Active Vs. Passive

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Active versus passive. Active or passive. The active-passive debate. Whatever the exact words, the theme dominates portfolio construction conversations. When we look at the performance of index fund investors, however, it’s clear that “either/or” is a false premise. The behavioral reality is that there’s a place for both approaches. In fact, a better way to characterize this portfolio construction theme might be active using passive.

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The industry has certainly witnessed an increased adoption of passive strategies over the past decade. For example, the chart below shows the growth in net cash flow of passively managed products that invest in U.S. equities. At the same time, active fund flows have struggled to keep pace. This seems to suggest that passive is winning the debate.1 However, there is a difference between a product’s strategy and an investor’s strategy.

Adoption of passive funds has grown

Note: Data reflect all ETFs and mutual funds available for sale in the United States that are invested in U.S. equities, according to Morningstar, Inc.

Source: Vanguard calculations, using data from Morningstar, Inc.

The chart above doesn’t tell the full story. If all investors who are choosing passively managed products are making a truly “passive” allocation to U.S. equities, then cash flows into these funds would be spread out broadly across the U.S. market on a capitalization-weighted basis. With each investor taking this approach, the asset-weighted returns of passive funds should closely track the returns of a broad-market index. But that’s not what we see.

It turns out that passive investors haven’t been making broad cap-weighted allocations to the U.S. market. The chart below shows the asset-weighted, rolling five-year relative returns of U.S.-domiciled equity index mutual funds and ETFs that are invested in U.S. equities relative to a cap-weighted U.S. total stock market index fund. Put another way, it reflects the performance of the average passive-fund investor.

Index-fund investors haven’t necessarily tracked the market

Active Vs. Passive

Note: Average index fund includes U.S.-domiciled index mutual funds and ETFs in the U.S. equity and sector equity categories, and its returns are asset-weighted. Average index-fund returns and Vanguard Total Stock Market Index Fund returns are relative to the Wilshire 5000 Total Market Index. Data are from 1993 to 2016. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Source: Vanguard calculations, using data from Morningstar, Inc.

Contrary to expectations, the average index-fund investor hasn’t exactly tracked the broad market. In fact, the excess returns versus those of a total market fund have fluctuated greatly, outperforming or underperforming the market by nearly 14% and 8%, respectively, at various intervals. Since a truly passive approach to investing would resemble the orange horizontal line slightly below zero (represented by Vanguard Total Stock Market Index Fund), this suggests index-fund investors have been building active portfolios.

By Jim Rowley of Vanguard, read the full article here.

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