Evaluating Active vs. Passive Investing: An Update
Our Investment PerspectiveNavigating the investment landscape can be challenging, especially when deciding between active and passive strategies. You may have heard that most active fund managers do not outperform benchmarks in the long run and fall short of their passive peers. While this statement is a widely accepted observation in investing, we believe it is an oversimplification that doesn’t fully capture the complexities and nuances of active management. Understanding the importance of manager selection and the construction of underlying benchmarks will provide investors with a stronger knowledge of their investment portfolio.
Passive investing is not without risk
The choice between active and passive management often depends on an investor’s goals, risk tolerance, and preference for cost versus potential reward. Many investors use a combination of both strategies to balance their portfolios. Passive investing offers simplicity and consistent market performance but lacks the potential for outperformance and flexibility in adapting to changing market conditions. As such, when markets decline, passive funds often have no reprieve from the fall.
Since the beginning of 2023, 86% of the S&P 500’s returns have been attributable to the 10 largest companies in the index, specifically those with any ties to artificial intelligence (AI). Those companies dominating market performance now constitute 37% of the index’s market capitalization, significantly above the long-term average of 21.6% 1. Their weighting in the index is much higher than their relative earnings contribution, making the case that investors have bid them up beyond justifiable valuations. The YCharts/Bilello chart below compares the weighting of the sector now versus March of 2000, just before the tech crash.
This phenomenon underscores the importance of active management as simply buying an S&P 500 index fund could mean an investor might risk being caught betting on yesterday’s winners. An active manager, on the other hand, could proactively reduce risk in the portfolio by diversifying away from these concentrated risks, providing protection in a down market. With higher volatility in recent months and geopolitical uncertainties on the horizon, capital preservation and downside protection are top of mind priorities for investors.
The importance of manager selection
Thanks to the rising popularity of tax-efficient ETFs, investors are now able to access active investment strategies at a lower cost. Although it has become difficult for active investors to outperform the index, leading managers (generally defined as top quartile funds and ETFs) have nonetheless demonstrated their ability to deliver excess returns compared to respective benchmarks 2. The longer the investment period, the more pronounced the effects of compounding excess returns. Additionally, active managers with lower costs tend to have the highest success rate over time when compared to their passive benchmarks, further highlighting the importance of manager selection.
Know what’s in your portfolio
Active management strategies can be extremely effective in less efficient markets such as mid-cap, small-cap, or international markets. A challenge of investing in index funds is that an investor will own everything within those fund’s benchmarks, including non-earners. This is especially true for small-cap sector: many profitable small-cap companies are choosing to stay private for longer or getting acquired by larger companies. As a result, the quality of small‑cap indices has deteriorated significantly, highlighted by the figure below - where more than 40% of the Russell 2000 Index, and the passive ETFs that track it, are currently losing money 3. Investors who embrace passive investing often pay too little attention to how stock indexes are built, and as a result, companies of low quality create an imperceptible drag that could cost investors hundreds of percentage points of gains over the years 4.
In bond markets, active fixed income strategies that proactively manage duration, sectors, credit, and yield curve positioning are more important than ever given the recent changes in interest rate policies globally. Within fixed income, the 10-year success rate for low-cost active managers (defined as percentage of funds that generated a return in excess of the average passive fund return over a time period) is higher than 50% 5.
Active management also offers flexibility for advisors to consider other aspects of your financial picture in a holistic manner. For example, a technology executive with a concentrated restricted stock position in Microsoft might not wish to be over-indexed to the S&P 500, which is also highly exposed to the technology sector. Another example is tax-loss harvesting: individual stocks and bonds offer more opportunities to harvest losses and minimize taxable gains compared to an indexed mutual fund or ETF.
At Buffington Mohr McNeal, our active management approach is guided by the bottom-up and top-down research we do to identify companies and market sectors with reasonable valuations and high potential returns. In the large-cap core and fixed income categories, where we manage portfolios in-house with no additional costs to external managers, we are happy to report strong performance year-to-date and over longer time horizons. For clients who prefer a passive investing approach, we also offer a rebalancer model that offers index exposure at minimal cost. As always, we are happy to discuss and tailor your investment strategy to meet your long-term financial goals and risk tolerance.
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Additional notes:
1 Data extracted from J.P. Morgan Asset Management, Guide To The Markets as of June 30, 2024.
2 J.P. Morgan, It is an active decision to go passive in equities, May 2024.
3 T. Rowe Price, Discover the potential of Active Small- and Mid-cap ETFs, March 2024.
4 The Wall Street Journal, The Junk in Your Index Fund is Costing You Big-Time, July 2024.
5 Morningstar, Active vs. Passive Investing U.S. Barometer Report, Year-End 2023.