Why Settle for Average?

With the recent flood of Wall Street Journal articles about passive investing, now is a good time to review the space.  Money is pouring into firms like Vanguard and iShares, the leaders in the indexing revolution.  Investors are seeing that despite perennial declarations of a “stock-picker’s market”, active managers consistently trail their benchmarks and charge large fees for the privilege of doing so.   You’ll see below that I am an advocate of passive investing, but only when it’s done correctly.  There are plenty of opportunities to use passive incorrectly or to get ripped off by a non-fiduciary product seller.

What is passive?  A passive investment is just a rules-based strategy.  Technically, there should be a corresponding index.  For example, if the rule is to weight the investment based on the number of vowels in the company’s name, there should be a high-vowel index that the strategy would use as a reference.  Don’t laugh; there’s some crazy stuff out there.  The mother of all indexes is the S&P 500, which is weighted according to market capitalization.  This means the larger the company is, the larger its weighting in the index is.  Passive is not necessarily low-cost.  Fund companies can still charge whatever they want for their products.  Look up S&P 500 index funds and you’ll see a wide range of expense ratios.

There are three main arguments I hear against passive investing:

  • Investing in an index means settling for average returns. Passive investors are quitters.  While they will match the index’s returns, they give up the opportunity for outperformance. You’re not average, are you?  Don’t you deserve more than average?
  • Active managers outperform during downturns.
  • The average active manager doesn’t beat the benchmark so why not invest in just the good active managers?

Why settle for average?

I love this argument.  It is valuable to me in my due diligence work as it lets me know that the person making that statement either doesn’t know what they’re talking about or is deliberately misleading.  Instant red flag.

The argument implies that the market is average, so half of active managers should beat it and half should trail.  Disregarding the error of mistaking average for median, let’s take a look at the actual results.

According to the latest SPIVA Scorecard (as of 6/30/2016), the average active large cap manager’s return was -0.38% over the last one year, 9.37% for the last 3 years, 9.64% for 5 years, and 6.06% over the last 10 years.  Not too shabby, but the S&P 500 returned 3.99%, 11.66%, 12.10%, and 7.42% over the same periods, blowing the doors off of the average active manager.  The S&P 500 outperformed 85% of active managers over the last 12 months, 81% over the last 3 years, 92% over the last 5 years, and 85% over the last 10 years.  If you truly settled for average, you’d need to underperform the index by 2-4% every year.

Giving up on outperformance

“But what about the upside?!?!  You will never outperform the benchmark if you index!”  When 70, 80, and even 90% of active managers lag their benchmark, is outperformance a realistic expectation?  Is that even an investor’s goal?  I have yet to meet a client whose goal is to outperform the S&P 500.  Investor goals are more along the lines of building enough wealth to retire or to leave a legacy of charitable contributions to a beloved cause.

I’ll tackle the remaining two arguments in later posts.  Spoiler alert: active management doesn’t win.