published: November, 30th 2016
By Rick Wedell, CIO
Market Update - Active vs Passive Investing
Many of you have asked me about my views on Active versus Passive investing, and so I thought that I would write up a brief discussion of the topic for this week. Now, first and foremost, it is important to understand that passive investors effectively free ride on the efficient market created by active investment managers. In essence they are saying that almost every stock is fairly valued relative to the information that is in the marketplace, because there are thousands of people doing research on every company and security to determine its fair price. Since the market is so efficient, a small investor doesn’t need to waste time or money doing research, because someone has done it for them and has appropriately priced the stock. The lynchpin of this argument rests on the idea that the market is efficiently priced due to all of the work of the active investors. Thus, at some point, we will reach a stage where so many folks are passively investing that the passive investors are actually, on the margin, setting the price. This was starting to happen in the High Yield asset class in my last few years there – fund flows from the ETF’s were so massive relative to the asset class size that bonds would frequently be mispriced relative to their peers solely due to their inclusion in the index. There are a variety of theories as to when we may reach (or have reached) that tipping point. Certainly the volatility created by massive index flows into and out of particular asset classes and sectors can drive temporary mispricing of individual securities, which active equity managers may be able to take advantage of. The larger point, however, is that when the market is dominated by ETF’s, active managers should prosper, and vice versa.
Second, people should understand that the returns associated with passive investing versus active investing vary wildly by asset class. Equities, one can argue, haven’t made a ton of sense to have actively managed over the past few years. Fixed income is a different story, as the chart from PIMCO demonstrates below. Why is that the case? Well, my theory is that it has a whole lot to do with the efficiency of the underlying market that we are dealing with. The equity market is highly efficient in terms of trading, and relatively small in overall name count – domestic large caps are really only about 1000 individual companies, which is not a lot in comparison to the millions of investors who look at them. By contrast, the global credit market is three times the size of the global equity market, and since every different issuer is likely to have multiple different tranches and seniority levels within their capital structure, the sheer number of individual securities to evaluate is mind blowing. Further, it is a market that trades with opacity – most trades are still bespoke from various dealers around the country. As a result, the market is less efficient, and active management has generally trumped passive.
2011 - 2016
The last thing that I would like people to understand about this debate is that the recent (post 2008) economic environment hasn’t exactly been conducive to stock pickers. Rates are incredibly low, and the market has been by and large driven by macro factors versus more company or industry specific trends. This tends to make a lot of the securities within the market correlate strongly with one another, which further drives down the dispersion of returns available to active managers. That said, the evidence suggests that the returns associated with active versus passive management are cyclical in nature – sometimes active beats, sometimes passive beats – as the chart below demonstrates. Just because the past few years have favored passive versus active does not necessarily imply that active investing is dead.
Source: Hartford Funds Fourth Quarter White Paper – The cyclical nature of active & passive investing
So where does that leave us? Well, I would argue that both passive and active strategies have a place in any well-balanced portfolio, particularly given that returns from active versus passive investing tend to move in cycles over time.
Have a great week!
Rick Wedell is neither affiliated with nor endorsed by LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
No strategy assures success or protects against loss. Investing involves risk including loss of principal. Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies. The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors. Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time. The prices of small cap stocks are generally more volatile than large cap stocks. International debt securities involves special additional risks. These risks include, but are not limited to, currency risk, geopolitical and regulatory risk, and risk associated with varying settlement standards. These risks are often heightened for investments in emerging markets. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.