Active Management is Dead as Investors Flock to These Index Funds

Image of empty airport chairsDavid Fabian: If there has been one dominant force over the latter stages of this bull market, it has been the switch from active to passive investment management.  There has been a tremendous movement of assets from traditional money managers to the likes of Vanguard, Charles Schwab, and other index-based platforms.  The latest iteration to try and capitalize on this trend are robo-advisors and their low contact, systematic approach.

The obvious benefits are lower fees, transparency, and comfort that you are getting the full breadth of every tick in the market.  You aren’t missing out on a 5 or 10% gain because your stock picking mutual fund forgot to own Amazon and Google.  Now you own those stocks and just about every other technology company in the world.

Active Managers

This has also translated to a distinct negativism towards any concept of strategy, positioning, or activity outside of quarterly re-balancing and “tax loss harvesting”.  Billionaire investors like George Soros, Carl Icahn, Stanley Drukenmiller, Jeffrey Gundlach, Bill Gross, and others are roundly mocked on social media for their views on stocks and bonds.

People simply roll their eyes and buy more Vanguard S&P 500 ETF (VOO) andiShares Core U.S. Aggregate Bond ETF (AGG).  They don’t want to hear about strategy.  They don’t care about risk management.  They have been told that passive management is the better way to go.

That is absolutely true as long as you are in a bull market.

Let’s face it – it’s easy to be passive when your accounts make money every single quarter.  The biggest bumps in the road over the last several years have been two 10-15% dips that were restored to breakeven or better in a few months.  If you just shut your eyes for a couple of weeks, you probably missed the majority of the volatility altogether.

Bear Markets

But what about when the market is down for six months or even a year?  Will you be able to stay with your newly minted passive portfolio when your account values have fallen 20 or 30%?  How will you react when correlations break, trends reverse, and the investment universe seems nonsensical?

The key to any strategy is that you have to stick with it through thick and thin.  You can’t be a huge bull on the upside and go to cash when you reach an unknown emotional pain threshold.  That’s how you end up missing out on the recovery phase and cause exponential damage to your investment returns.

Portfolio Composition

Furthermore, this trend towards passive investing has resulted in a distinct lack of imagination with respect to portfolio design and structure.  The S&P 500 and Barclays Aggregate Bond Index are worshiped to the extreme.

There is such a fear of missing out on the mainstream benchmark returns that any flair for independent thinking, unconventional position sizing, or primary research has been relegated to obscurity.

Even hedge funds, once the last bastion of uncorrelated returns, are becoming further and further correlated to major world benchmarks.  They slowly eliminated the “hedge” to keep up with the performance on the upside.

ms_hedgefund_correlationSource: Morgan Stanley, Business Insider Jan 2014

Everyone thinks they are a contrarian.  The reality is much more complex.

The Second Act

The active investment manager is a dying breed.  Yet, in my opinion, there will come a time when investors need those types of strategic thinkers once again.  Active managers are due for an encore or second act, as it may be.

What might that look like?

Investors who look for value when others are only seeking momentum.  Those who are able to read the prevailing market winds and change tactics as conditions dictate.  It may even be those who are willing to overlook a few percentage points on the upside in order to create stability on the downside.

That is likely to be a sought after skill in both the stock and bond markets.

The hard part for investors is choosing what type of active manager to go with.  They aren’t all the same and should be judged based on their own merits, investment tools, and philosophy.

I find myself most closely aligned with a strategic asset allocation approach.  Someone who is comfortable reducing exposure into a big rally or looking for opportunity in the midst of a sell-off.  This means allowing for more flexibility in overall asset allocation and security selection.  Nipping and tucking various areas of the portfolio to make incremental changes as conditions dictate.

This comes with the caveat that I won’t capture every single tick on the upside.  It’s a form of market timing, which means I can miss out on certain trends that extend further than I had anticipated.

However, it’s a small price to pay for the freedom to think critically about what will drive risk and return in the future.  Some of those risks can be mitigated by having minimum exposure limits on certain asset classes as well.

It’s not just security selection, but also behavioral guidelines that can have a marked impact on your future returns.  So much damage is done by chasing prices higher and selling lower.

The Bottom Line

There is no way to know when the pendulum will swing back from an extreme love of passive investing to a more neutral acceptance that both strategies have merit.  It may come in the form of a bear market or simply a constant reshuffling of leadership that lends itself to a more active approach.

I’m not forecasting any near-term doom and gloom.  I’m actually quite optimistic overall.  Nevertheless, we will experience a difficult investment environment once again at some unknowable point in the future.

I believe, under those circumstances, the active manager will be one of the best tools in your arsenal.

The Vanguard 500 Index Fund (NYSE:VOO) was mostly flat in Monday morning trading. VOO, which is the third largest ETF that tracks the benchmark S&P 500 index, has risen 7% year-to-date.


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This article brought to you courtesy of FMD Capital Management.

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