The active vs. passive debate continues to rage across Wall Street. The passive guys believe that active money managers can’t beat a passive index so the fees they charge aren’t worth it. The active guys believe they can beat a passive index, even though they really haven’t, so the fees they charge are worth it. I’m not going to argue either way because they both stink and the real answer is active tactical management, but the argument ignores one key point—the state of the market.
Vanguard pioneered the idea of passive management in the 1980’s. The idea was that since most active managers don’t beat their benchmarks, investors are better off just putting their money in passive indices which charge much lower fees. Obviously the idea has caught on since Vanguard is massive now. Vanguard’s argument has a lot of merit. Most active managers are so afraid of under performing their benchmark that they get as close to it as possible. Add in a fee typically 1% or more and you are almost guaranteed to under perform. Active managers who substantially deviate from their index have a lot of career risk as they have the possibility to outperform, but they can also under perform for long periods of time.
Active managers appeal to investors from the standpoint of the one major flaw of passive investing is that it is impossible to beat the index, because you are the index. Deep down most of us want the have the possibility of beating the market so active management is appealing because it can provide that chance.
The key thing that the debate misses however is what is the state of market currently. When Vanguard started preaching passive investing in the 80’s where were stocks and bonds? Interest rates were at historic highs, meaning bonds we undervalued, and stocks were at attractive valuations as well. What happened? All bonds and all stocks rallied. In an environment when everything is going up it is going to be extremely hard to beat a passive index, which is what happened. Fast forward to today, what is going on in stocks and bonds? Interest rates are at historic lows and by any measure you look at stocks are overvalued. Given this environment what is likely to happen over the next 10 years or so? Bonds and stocks are probably going to struggle. Which means that passive managers who just buy the stock market or just buy the bond market are also likely to struggle. On the other hand, stock and bond pickers will have an unprecedented opportunity to outperform. Will they? Who knows, if they continue to hug their benchmarks then they will squander the opportunity, but the truly good stock pickers will have a chance.
How can investors take advantage of this? First we can clone the top stock pickers. Every money manager is required to publicly report their holdings on a quarterly basis. There is a 45 day delay but chances are if you are looking at a manager who buys and holds over long periods of time then they still own what they held 45 days ago. There is a ton of good research showing that investing in a money manager’s top holdings typically outperforms the money manager. This makes sense as you are investing in their top conviction positions. So you can create a list of long term buy and hold stock pickers and clone their top holdings. Just doing this is powerful but it won’t protect against market declines. Instead of buying and holding the portfolio of stocks, you could invest in them tactically, possibly using some sort of relative strength, intermarket analysis, or counter trend analysis. You could also put in a tactical overlay of some sort that can move to cash, short the market, and/or buy volatility.
Trying to debate active vs. passive management in the rear view mirror is a recipe for disappointment for investors. Instead take a forward looking approach of where the market is now to determine what will likely be the best strategy going forward.