However, most of the debate around active versus passive investing comes from those advocating for one approach over the other. We, on the other hand, believe they are complementary and not mutually exclusive. Based on our research, neither an all-passive, nor all-active portfolio, is an optimized portfolio. Rather, optimal appears somewhere in the middle, hence our comparison to yin and yang.

The case for passive investing

Narrow-based market

For many years, the Standard and Poor’s (S&P) 500 performance has been driven by a small number of stocks, which is called a narrow-based market. Actively managed portfolios that do not own a handful of these stellar performing stocks may underperform the index.

Typically, only 10 stocks drive most of the S&P 500 return (in years where the S&P 500 is up 3-11%). Therefore, the importance of owning the few stocks that significantly outperformed can’t be overstated. 2020 is no different. This year the five largest stocks in the S&P 500 index represented 24% of the index. These five mega-cap stocks are up 49% year to date as of August, the remaining 495 stocks are down 2.9%.

When the market is narrow based, including passive investments in a portfolio is clearly beneficial.

Fees

Passive funds simply replicate an index like the S&P 500 or the Russell 2000 and have lower management fees than actively managed funds. Fees negatively impact a fund’s performance, and over the years there has been downward pressure on management fees on both passive and active managers.

Remember, though, fees should be part of the investment process, not drive the investment process. Is the least expensive automobile the right one for you and your family? Perhaps not.

Efficient markets

There is an academic theory called the efficient market hypothesis (EMH) that suggests it is impossible to beat the market. If the market is efficient, share prices reflect all relevant information and trade at fair value; therefore, active managers can’t outperform the market.

I would counter that some markets are efficient and others are far from it. For example, in the past 10 years ending June 2018, 94% of U.S. large cap core managers underperformed their respective benchmark, suggesting the market is efficient. However, in the same period, only 63% of international small cap managers underperformed their respective benchmark, suggesting that market is inefficient.

The jury is still out on EMH. However, some markets and asset classes are more efficient than others, once again supporting the yin and yang case of using both active and passive investments in your portfolio.

The case for active investing

Valuation

When discussing active versus passive investing, active managers have the discretion to own companies in which valuations are attractive and avoid firms that are excessively valued. For example, in July 2018, Netflix (NFLX) reached a high of $419 per share and traded at over 120 times earnings. As valuation became stretched, active managers had the choice of avoiding Netflix during its 44% decline from $419 to $233 over the next six months. This is in contrast to a passive index strategy that has no such choice as to whether to own Netflix. Therefore, active managers can outperform their stated benchmark by making active calls such as avoiding high or excessively valued securities.

However, we believe that over entire market cycles, valuation matters. Historically, sooner or later, overvalued stocks underperform and undervalued stocks outperform. Most active managers attempt to buy undervalued stocks. By doing this, they can control risk and perform well over a market cycle.

Quality

If the index was dissected into high-quality stocks (rated A+ to B+) and low-quality stocks (rated below B), as defined by S&P, it would show they perform differently at various times. Low-quality stocks outperform during the early stages of a cyclical bull market, while high-quality stocks perform best in a bear market. Of course, the index owns both high- and low-quality names.

When safety trumps valuation, high-quality names will protect the portfolio. Thirty-three percent of the companies in the Russell 2000 index lost money last year, while high-quality stocks have not experienced negative returns over any 10-year period since 1986. Typically, active managers search for quality investments.

Dividends

Dividends play two important roles. First, they can be a material factor in total return. If stock prices appreciate 5% and there is a 3% dividend yield, the total return is eight percent. Importantly, 37.5% of the total return came from dividends.

Second, as companies pay and increase dividends, it sends a message that management is confident that earnings will increase. Since 1972, stocks that increase or initiate their dividend have outperformed the market by 2.3%. During this period, dividend growers and initiators returned 9.6% annually versus the S&P 500’s 7.3%.

Active managers can build portfolios that seek out stocks with attractive and growing dividends.

What’s not in an index?

In 2020 a pandemic crippled the global economy. Yet a number of companies helped businesses and consumers through the shutdowns and the shelter in place orders. Many of these stocks have performed well and may not be in an index. Here is a brief list of companies that are not in the S&P 500 index and their returns year to date as of August:

Company YTD returns 8/31/20

Square Inc. 155%

Zoom Video Communications 377%

DocuSign Inc. 201%

Splunk Inc. 46%

Workday Inc. 46%

Lululemon Athletica Inc 62%

Wayfair Inc. 228%

Tesla Inc. 496%

S&P 500 9.7%

All investing is active

Portfolio management requires numerous decisions. Asset allocation is paramount—which asset classes should be in the portfolio, and what allocation? Even if passive securities are to be used, which index is appropriate? For example, the 2018 return for three passive small capitalization exchange-traded funds, each with their own underlying index, had a 2.6% return variance:

  • iShares Core S&P Small Cap, -8.5% return
  • iShares Russell 2000, -11.1% return
  • Vanguard Small Cap ETF, -9.3% return

Every component of portfolio management requires a well thought-out and researched decision. Thus, all investing is active.

The yin and yang

Passive and active management styles are not opposite or contrary; they are complementary. Given our research on active versus passive investing, we believe using both styles strategically in portfolio management creates an equilibrium and holistic strategy.

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