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Owning Passive ETF’s Doesn’t Make You Passive

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Owning Passive ETF’s Doesn’t Make You Passive

Within the investment industry, there is an ongoing debate about the efficacies of passive and active investing. Vanguard has been one of the more vocal participants in evaluating active managers and the consequences of stock-based investment strategies. Academic research into the matter confirms Vanguard’s hypothesis: Most managers that claim to be active are not consistently adding value to the market return. Each year is pronounced the year that active management will win, but this is rarely the case.

Why does active management seem to be so ineffective at beating the market?

The majority of the investment community attempts to add value by selecting individual stocks. Investors weigh one company or theme more than others. Investment managers spend their time searching for inefficiencies in the valuation of individual companies in order to outperform the market.  However, much like any free market, the more individuals focus on finding inefficiencies, the fewer inefficiencies there are to exploit.  It therefore comes as no surprise that the significant research staff and budgets of the largest mutual fund complexes are unable to outperform a passive collection of stocks: their size and past success has resulted in an efficient market.

Is the only solution then a static allocation of passive, market-weighted investments?  No — inefficiencies will always exist.  Therefore, the plan should be to seek out inefficiencies and exploit them.  With nearly everyone fishing the same pond for individual company opportunities, it might serve investors to look for fishermen that have elected to change ponds and fish where ample opportunities exist. 

Research consistently shows that the two largest components to long-term investment return are market participation and asset allocation.  However, very few of the large firms focus on those factors.  Instead, they focus almost all of their attention on finding the next Google, Proctor & Gamble, or Home Depot.  This issue was highlighted in a CNBC panel on October 20th, 2015 with leaders from three prominent mutual fund families.  They all promoted active management, focusing on stock selection and argued that 2015 was the year of the stock picker.  When the host asked if they ever make asset allocation calls or market participation calls, the CEO of one said they leave that decision to the client.  These three large investment firms readily admitted to leaving the two most important investment decisions to the client.

As a result, there is no question as to why the mutual fund industry continues to see asset losses. The industry’s leaders are unable to grasp the real needs of the individual.  Studies show that individual clients lose over 2% a year in annual return because they get scared out of the market at the worse time and reinvest at higher prices.  Over 25% of the hoped-for return in the equity market is lost to mistiming, yet the investment industry seemed unable to restructure itself… until recently.

The financial crisis of 2008 was a wakeup call to investors and some forward-thinking asset managers. The historical method — static allocation of diversified assets throughout the business cycle — was found to be flawed.  Diversification, the idea that a broad mix of asset classes will protect investors against material losses during market downturns, was proven wrong when almost all asset class returns went negative.  Diversification failed when it was needed most, creating a crisis of confidence.

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Being Active with Passive Vehicles

With the recession fresh in everyone’s minds, the idea that modern portfolio theory (MPT) was the solution to all investment problems was called into question.  Research suggests that many of the inputs required for the application of MPT change throughout the economic cycle, leading to inefficiencies in portfolio positioning in the various stages of the cycle.  Because many larger investment firms have not embraced this realization, new firms have been the ones to pioneer the approach.  Using the knowledge that portfolio positioning should reflect the different phases of economic growth, these firms spend their time determining those phases and the asset allocations that improve their clients’ chances of succeeding throughout the cycle.

The implementation of this process, which involves adjusting asset allocations based on economic cycle phases, draws investment focus to areas where inefficiencies are greatest: market participation and asset allocation.  Firms advancing this process do not waste time on the unproductive goal of determining which companies will outperform.  Instead, firms obtain exposure to the desired asset class or style by using lower-cost, passively based investment funds. 

In this new era, the debate over active versus passive management is becoming obsolete.  Rising firms are active participants, choosing to focus on elements where inefficiency can be captured and accretive to client returns. 

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