The ongoing debate between “active” portfolio management and “passive” management is again a hot topic as 2014 comes to a close. Active management refers to investors who pick their own stocks, presumably with the goal of outperforming a market index or portfolio benchmark. Passive management refers to simply investing in an index fund and thus receiving the market’s return.
The root of the argument centers on the cost of active investment management. Numerous studies have shown that many active managers underperform an index over time, with the gap in returns mainly due to investment management fees.
This year has been a particularly poor year for active managers. Just 14 percent of large-cap mutual funds have beaten the S&P 500 index, which has risen nearly 15 percent on a total return basis. Hedge funds have had another miserable year—equity long/short hedge funds, whose mandate is to beat the market, have earned only 1 percent this year. When all hedge funds are included, the average fund is up a meager 3.5 percent.
There are a few reasons 2014 has been a tough year for professional investors. Market volatility has been low, so there were fewer opportunities to buy stocks during downturns. Also, smaller stocks have underperformed larger stocks by the largest margin in 15 years. The Russell 2000 index of small companies has risen only 6.4 percent year-to-date. Last, money managers who were not fully invested throughout the year would have had a more difficult time keeping up with market indexes.
That said, investors should not let active managers off the hook when reviewing longer-term performance periods like five- or 10-year annualized returns. Here, for example, many hedge funds have posted poor five-year returns as their managers, apparently still scarred and apprehensive following the credit crisis, maintained a low exposure to stocks.
Inexplicably, money flows into hedge funds over the past five years have been strong. We attribute this to institutions allocating funds to these high-cost vehicles on the advice of their investment consultants. Now that the California Public Employees Retirement system has decided to exit hedge funds, more institutions probably will find the backbone to do the same.
Nonetheless, the conclusion to simply invest in index funds has a few caveats, too. In a market environment like today, following a significant increase in stock prices, an index investor is investing more of his money in the stocks that have done the best. This is because of the way most index funds are constructed, where the largest and better-performing stocks have a greater percentage weight.
A combination of index funds and certain kinds of active management make for a nice portfolio. An index investor will do well by adding money when stock valuations are cheap and taking some profits when stocks are highly valued.
When seeking active management, look for managers who pay attention to valuation, are contrarian, and who are not overly diversified. Avoid actively managed funds and managers who buy a broad allocation of stocks that essentially mimic an index. These so-called “closet indexers” will lag the performance of an index fund due to their investment fees.•
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or firstname.lastname@example.org.