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The Real Reason Active Managers Underperform The S&P 500 Index

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The Real Reason Active Managers Underperform The S&P 500 Index

What The FOMO Is Going On Here?

While at Newark airport recently, I noticed an advertisement from an investment management company promoting “Emerging Market Alpha.” My reaction: the headline for this article.

You see, there was a time not long ago when phrases like “active management,” and the Greek/Wall Street language of alpha, beta and the like were strictly confined to those of us in “the business.” So, when I saw this, I thought for a moment that perhaps what my peers and I have dedicated our lives to since the 1980s was finally going “mainstream.” You know, like gyros, quinoa and yoga once did.

The investment liberation movement

It occurred to me that there is a lot about the investment business that is going mainstream. Much of it is great, liberating the individual investor in a way that most of us could not have imagined way back in the days of waiting on a line in the World Trade Center to get stock quotes from our broker’s Quotron terminal.

However, this is another darker, and potentially more dangerous side to the total democratization of investing. Whether it’s commissions going to zero, ETFs getting brought to market at a more rapid pace, or the marked gap between regulation for those in the “regulated investment advisory” business (like me) and those who are not, there is a risk that investors get tricked. Frankly, my entire body of work at Forbes.com is devoted to confronting that, from many different angles.

The problem with uber-dissemination of information without a filter is that it tempts people to do things based wholly on what they know. It doesn’t help them account for what they DON’T know. While I could probably devote an entire weekly series to the latter, here is one example. Hopefully, this will simply make you stop and think as the major stock market indexes continue to run amok.

“Most active investment managers don’t outperform the S&P 500”

You have probably read this many times. And it is true. However, it is true in the same way that people use more sunscreen in Florida (where I live) each year than in New Jersey (where I grew up). Floridians use more sunscreen because they are at greater risk of contracting skin cancer. The sun is out most of the year, and the days are longer because we are further west than New Jersey in the Eastern time zone.

What does this have to do with active managers versus passive, indexed investing? The S&P 500 has had a great run for over a decade. There are few market segments, in the equity, bond or commodity markets that have kept up with it. In such an environment, those sorry active managers can’t catch a break. That is, unless they have force-fed a small number of tech mega-giants into their stock portfolios, and kept them there.

However, this is just a distraction from the facts. The real reason most active managers have not outperformed the S&P 500 Index over the past 3, 5 and 10 years is this: they aren’t trying to. And, if they did try to, they would probably be out of business before long. 

If risk also matters to you, read this…

Risk-management is very important to many investors. You know how much risk-management there is in an S&P 500 Index Fund? NONE. Do you know why? Because it is, by mandate, required to invest in the 500 stocks in that index, in the same relative amounts that the index does.

So, if stock XYZ is 5% of the S&P 500, and it jumps in price, your index fund will likely have a nice day. If it gets pummeled, so does your Index fund. The problem I see building here is one of FOMO – Fear of Missing Out. It has created a mania that blinds many investors to the risks of simply “owning the market.”

That said, S&P 500 Indexing is cheap. There is no need to pay anyone else to do it for you. Index funds are easy to find, easy to buy and easy to track. That is part of the open-access world of ETFs, online trading and zero commissions.

What S&P 500 Index funds don’t do for you

That style of investing does not manage risk for you. An index fund manager is not paid to guard your $1,000,000 portfolio so that it doesn’t become an $800,000 portfolio. That is what happened to the S&P 500 in about 12 weeks at this time last year.

Here is a chart that to me, is the “mic drop” on how investing can work for you when you put some effort into thinking about risk management. What you see here is the performance of the S&P 500 ETF (symbol SPY) going all the way back to the start of 2005. It is matched up against a mix of 67% SPY and 33% in symbol SHY, which is just 1-3 Year U.S. Treasury Notes.

Short-term Treasuries are a pretty benign investment choice for a long-term portfolio. However, the point here is just to show what happens when you take your foot off the accelerator as an investor, in exchange for having some cushion for your wealth during recessions. I did not use longer-term bonds or “credit” bonds like corporates and high yields here. Those involve an element of risk that investors may not wish to have when the economy is rough. 

There are 2 things to note about this chart:

  • The all-S&P 500 portfolio is about even with the 67%/33% SPY/SHY portfolio over this nearly 14-year period.
  • It took that all-S&P 500 portfolio over a decade to get back even with that simple risk-managed mix after the last recession. Note: that recession only lasted about 18 months! So, it took nearly 11 years to erase the damage caused by 18 months of financial hell. 

That is why before you plunge into passive management, active management, or some combination of the two, you need to look inward. What do you want to achieve by borrowing the liquidity, growth potential and income potential of the public stock markets? How much return do you want, and how much do you need? Those are often different answers, and the gap between the two is THE key ingredient in FOMO. And it is an epidemic among investors today.

An objective(s) look at this issue…and something about pizza

The danger to your wealth is even larger if you try to evaluate active managers who don’t invest their entire portfolio in stocks. Bond managers, asset allocators and hedged investing types (like me) do not wake up every day and wonder, “how much can I make?” No, our purpose is to balance reward and risk within the realm of the OBJECTIVES of our audience. 

Trying to compare a mutual fund whose primary objective is “capital preservation” to an S&P 500 Index fund is like going to an Italian restaurant and complaining that they don’t have pizza on the menu. Not all Italian restaurants do. That is not because the owners of those establishments are stupid. It is because they are seeking to deliver a different experience through their menu. It probably involves tomato sauce, cheese and bread. But those ingredients don’t have to add up to pizza.

Likewise, not all investors pursue the same experience. Some just want to get the S&P 500 Index return. In the past 10 years, that would have produced a big number. In the 10 years prior, it would have produced about zero. From the tail end of a stock bull market (which is likely where we are now), it produced a 40-50% drop in value, before eventually storming back, and then ahead.

Who are you (who-who, who-who?)

What kind of experience do you want? More importantly, what kind of investment experience do you NEED? We all want as much as we can get, but that does not mean we ignore all of the risks of achieving that growth. Assess who you are as an investor, and where you are in the path toward retirement. Then, invest accordingly. And leave the FOMO for somebody else to recover from.

Related: The S&P 500 Is Telling Us That Impeachment Matters. Here’s The Evidence

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