Robo-advisors have seen huge inflows over the past decade, as investing is now as easy as checking a few boxes on an online questionnaire and linking your bank account. Whether you are saving for retirement, want to build towards a down-payment on a home or even just fund a vacation, programs that use an algorithm to invest in index-tracking ETFs have great appeal. And because we have been in a history-making economic expansion – 10 years and counting as of July 2019 – both the stock market and some parts of the bond market have been posting gains year after year.However, Wall Street consensus has now coalesced around the opinion that the economy has entered the “late stage” of the business cycle – the one right before a recession. This stage typically sees increased volatility and slower growth. We’re taking a closer look at whether the premise of robo-advisors – that the lower cost of passively tracking the market will outperform active investing over time – will be likely to stand up to a different phase of the business cycle. We’ll also discuss whether a passive approach to investing, even when overlaid with risk profiling and goal setting, is the best way to think about your financial future.
2009-PRESENT: UNPRECEDENTED INTERVENTION BOOSTED RETURNSIt’s easy to see why low-cost passive investing has rapidly scaled assets – since 2009, the S&P 500 has posted several yearly outsized returns (over 20%) and an average annualized return of 14.3%. While the bond market has not performed as well (equities and bonds are usually inversely correlated), bond ETFs have also gained momentum as investors used them to fill out asset allocations. But there’s a deeper story to tell. Several atypical events have been major forces in the market, due to government response to the Global Financial Crisis. Government stimuli targeting industries was significant, including bailouts, business investment programs and tax rebates. Once the recovery was underway, investors re-entered the market, and with stock price levels depressed from 2008 losses, stocks experienced significant lift. In addition, Federal Reserve policy of slashing rates followed by three rounds of quantitative easing resulted in a healthier economy and increased the attractiveness of risk assets – a classic case of a rising tide lifting all boats, and a perfect scenario for index-tracking investments. If we take a perspective on the market over multiple decades, a different picture emerges. Over the thirty years ended June 2019, the average annualized return of the S&P 500 is only 7.2%. (see Chart 1). The longer investment horizon incorporates several cycles of economic expansion and contraction, and provides a more realistic way to match market returns to an investor’s timeframe.
SEA CHANGE: A NEW PHASE BRINGS NEW CHALLENGES – AND LESS SUPPORTWith the economic cycle firmly in late stage, economists are projecting slower growth as the effect of government stimulus fades and business investment remains soft, and increased volatility as individual stocks peak and decline. The path of interest rates is increasingly unclear, which weighs on both bonds and equities. In addition, global geopolitics, trade tariff negotiations and the upcoming election in the U.S. can only increase uncertainty.
ASSESSING ADDED VALUE: MEASURES OF MANAGER SKILL ARE EASILY ACCESSIBLEIn this environment, fundamental research at the stock level, and economic research in sector and geographic allocations can add value. However, it‘s important to note the “can”. Not all managers have equal skill. When comparing active management to passive index tracking, it’s common to see all managers in an entire universe compared to an index. We believe this can be misleading. Information on fund manager performance is widely available, and there are adequate and accessible forms of measurement – everything from in-depth analysis of fund history to simpler statistics like asset size and tenure – that can serve as an assessment of manager skill. Limiting the universe of active management to those managers that market participants and analysts have already decided possess such skill, either by investing with them consistently or comparing their returns to others in the same peer group and ranking them, can provide a more subtle and meaningful analysis.
A MORE APPROPRIATE UNIVERSE AND TIMEFRAME UNCOVERS SOME HOME TRUTHSIn the analysis below, the two principles outlined above are combined: the investment timeframe is longer to provide perspective beyond the current cycle, and the universe of active funds in each asset class is a simple average of the 25 largest by assets under management as of December 2018 with manager(s) tenured 10 years or more. Metrics presented for the Passive Fund are those of a single, investable index fund that tracks the same index against which the active funds in each asset class are benchmarked (e.g. in the US equity asset class, Passive Fund metrics are those of SPDR ® S&P 500 ETF (SPY)).1 The most important metric is that all returns are presented net of fees. As can be seen in Chart 2, over a 19-year period, in every asset class active investing outperformed passive. Looking at the data, the incremental outperformance ranges from 0.8% to 3%. Some investors may feel that the ease of passive investing outweighs the additional return. Looking at returns expressed in average annual return percentages instead of the growth of an investment in dollars over the same time period provides a measure of distance from the impact on an investor. Examining how a hypothetical portfolio would perform in cumulative return expressed in dollars earned by active management vs passive indexing can help investors quantify the gains. Chart 3 presents the growth of a $10,000 portfolio over the same 19-year period. All asset classes improved the original investment – effectively making the case for long-term investing – but the active managers were able to add significant value, as in the case of Small-Mid Caps (an inefficient market) where manager skill more than quintupled the initial investment.
- The full list of passive fund indices is as follows: U.S. Equity – SPDR ® S&P 500 ETF (SPY); Int’l Equity – Vanguard Total Int’l Stock Index Inv (VGTSX); Fixed Income – Vanguard Total Bond Market Index Inv (VBMFX); U.S. Small-Mid Cap – IShares Russell 2000 Small-Cap Idx Instl (MASKX); Vanguard Emerging Mkts Stock Idx Inv (VEIEX).