February 2017

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Passive versus Active Investing

The recent unseasonably warm weather and complete absence of snow this year in the Chicago area has been a very pleasant surprise. Flowers are pushing up through the soil and many migrating bird species have arrived a bit earlier than normal.

What’s not so surprising is the ongoing debate in investment circles about the relative merits of active versus passive investing. Passive investing refers to the use of mutual funds or exchange traded funds that replicate well-known market indexes such as the S&P 500 or the Russell 3000. Active equity managers attempt to beat the market by offering superior stock picking.

Investing in passive, index-based strategies has grown enormously in popularity in recent years. Last year alone, Morningstar estimates that $262 billion moved from active to passive U.S. equity funds (1). This is understandable: Index-based funds tend to have lower fees than active funds (1) and the average active manager does not outperform its index benchmark after fund fees and expenses (2).

While the trend from active to passive seems to be showing no signs of slowing down, although, in theory at least, there is a limit to how far it can go. The reason is that indexes use only one characteristic to rank the constituent stocks: price times the number of shares of a company’s stock. Market value, of course, depends on price. And how are prices determined? Buying and selling of those shares on stock exchanges done by active managers.

The price of a share of stock is a critical piece of information for skilled active managers, especially value investors. Value investors, such as Warren Buffett, seek to buy stocks that are undervalued and cheap relative to other stocks. They analyze the fundamentals of a company to arrive at an estimate of what the intrinsic value of a stock is, then compare that to the current price. If there is a sufficient discount (or margin of safety), the value manager purchases the stock in the hopes that eventually other investors will agree with that valuation and bid the price up to its fair value (or higher).

Academic research has consistently shown that value investing outperforms growth over long periods of time, though it may underperform growth for shorter time periods. One problem with passive investing is directly related to its sole reliance on price valuation because popular growth stocks will always have a greater weight in the index than unpopular value stocks. Popular growth stocks also tend to have more price volatility.

This became abundantly clear during the dotcom bubble of the late 1990’s when technology stocks (growth stocks) were everyone’s darling, eventually driving the tech sector to a weight of over 29% of the S&P 500 Index. That bubble ended in a three year bear market, where value investing (buying cheap stocks) outperformed growth (owning popular stocks) seven years in a row.

While some may worry that our “Early Spring in February” may not end well for the flowers when the freezing weather returns, we need not fear that active managers will be driven to extinction by passive indexing any time soon. Skilled and experienced equity managers who can find quality companies with good fundamentals, purchased below their intrinsic value with a “margin of safety”, should always have a prominent place in every investor’s portfolio. The goal is to grow wealth over the long haul by diversified exposure to the global capital markets, capturing a share of what the market has to offer as cheaply as possible, with less volatility, and avoiding the never-ending parade of popular investment fads.

(1) Morningstar Direct Asset Flows Commentary Feb. 14, 2017
(2) https://us.spindices.com/documents/spiva/spiva-us-mid-year-2016.pdf