Active vs. Passive Roundtable
The Investment Committee of 7258 Wealth Management meets regularly to discuss various aspects of client portfolio positioning, valuations, and market conditions and opportunities. Recently, the conversation turned to active and passive management.
Q: What is passive management?
Steve Trainer, 7258 Portfolio Manager [ST]: At its core, passive investing provides a return equal to that of a selected market. It allows an investor to gain exposure to the market without identifying specific companies. If an investor wants to own stock in large US firms, an S&P 500 index may be a viable option. This passive strategy holds many of the underlying securities of the index, mimicking the return of the S&P 500 on a pre-tax, gross of fees basis.
Eric Holt, 7258 Founder & President [EH]: Steve, while I would agree that a passive strategy tries to mimic a given index or market, I would broaden your definition to include a low turnover approach. Portfolio turnover measures the amount of buying and selling that happens in a year, and we can use that number to measure the amount of time the manager holds the average security. For example, if annual turnover is 100 percent, the average holding period in the portfolio is one-year. Higher turnover means more frequent transactions and shorter holding periods; shorter holding periods likely mean gains are taxed at less favorable rates.
ST: So you think there are two elements to being passive? Providing an investment that behaves like a given market and has lower turnover?
EH: Steve, portfolio construction (the portfolio tracking a market) and manager behavior (portfolio turnover) are two really good tests for being passive. If you built a portfolio that looks and acts nothing like the market but had very low turnover, that’s not passive in my mind. Conversely, if you build a portfolio that looks a lot like the market but has high turnover, that’s not passive.
ST: In the latter case, an investor is likely paying higher fees for a portfolio that tracks the market. That boggles my mind.
Q: What is active management?
William Jennings, 7258 Director of Research [WJ]: Active investment generally implies seeking outperformance within an asset class via security selection and market timing. Instead of seeking the simple return of an asset class, active management pursues an additional return. Active managers want to add so-called “alpha” from trading strategies to an investments’ inherent “beta” return. As Eric suggested, that probably means much higher portfolio turnover, with all of its tax consequences.
EH: An active manager will typically construct their portfolio to look different from the market/index they are being measured against—typically, they will hold fewer securities than the benchmark and the amount they allocate to sectors and industries will stray from the benchmarks as well.
WJ: In addition to being active within an asset class like we’ve been talking about, investors can be active or passive between asset classes. The pieces (each investment) can be passive but the whole (the portfolio) can be active. It’s worth noting that it is possible to be completely passive with respect to security selection and market timing in an asset class, but intelligent and prudent about trading and tax management, which might be called active. That sort of active management is the right thing to do for clients.
EH: Bill, those are important distinctions. Being active or passive should be assessed at the portfolio level. If a manager frequently trades within a portfolio, that behavior is active and will cost the client more, which makes it harder to keep up with the benchmarks. To your other point, being active on taxes and being thoughtful about rebalancing is very different from being active in stock selection, market timing and portfolio construction. One adds risk; the other reduces it.
WJ: The evidence for active tax management and active rebalancing is much stronger. Q: Doesn’t passive investing involve index funds and ETF’s?
ST: Index funds can be a great option for many investors who want to adopt a passive style of investing. They often have low expenses, minimal turnover, and are simple to monitor. For others, it may be appropriate to construct a portfolio that mimics the selected index by holding a representative sample of the individual stocks in that index. This index-tracking, individual-stock approach allows the manager to harvest losses at the individual security level, enhancing the investor’s after-tax return.
WJ: So, there are ways to be passive without index funds. As Eric noted, using index funds does not mean an investor is necessarily passive. Behavior of the overall portfolio matters. Day-trading index ETFs is in no way passive. Additionally, there are leveraged ETFs, which somehow turn 5% index turnover into 93% ETF turnover through daily rebalancing. Again, that’s not passive.
ST: The proliferation of new ETFs seems to be consistent with your point, Bill. The industry is trying to capitalize on different ways to package ETFs and some are definitely evolving into more than just index-tracking securities providing intra-day liquidity.
EH: Most ETFs track various indices like the S&P 500 or the Russell 2000. These would be passive ETFs, which are valuable building blocks in a cost-effective, globally diversified portfolio. However, more recently, a handful of actively managed ETFs have been introduced. These active ETFs are baskets of securities that trade throughout the day. These active ETFs are typically more expensive and less tax-efficient than traditional passive ETFs.
ST: Eric, when we worked at Bernstein, who would have ever guessed they would launch ETFs? But they are a perfect example of active management in an ETF wrapper.
WJ: I’m amazed at how the use of ETFs has changed over the last fifteen years. Many investors think ETFs and passive are synonymous but that’s not necessarily the case; some investment advisors actively buy and sell ETFs in an effort to outperform markets and this activity reduces or eliminates the advantage of having a lower-cost, more tax-efficient approach. Evidence suggests the use of ETFs has evolved over the last fifteen years. [See chart showing how broadly-diversified equity ETFs share of the market has declined.] Part of the evolution is rolling out more Fixed Income and International ETFs, but the use of Sector and Alternatives has also increased dramatically. It’s possible to use Sector ETFs passively, but I suspect some advisors are primarily using them to tactically overweight certain portions of the market and regularly changing the positions as dictated by their view of economic and market conditions…which is very much active management.
EH: Actively trading ETFs is a little like eating a large pizza after a 10-mile run. It kind of defeats the purpose.
Q: Do costs factor into this discussion?
WJ: Absolutely. Every dollar a client pays within their portfolio is a dollar that is not invested. We’ve all seen the evidence that higher-cost solutions make it very, very difficult to outperform benchmarks. It’s just too hard to overcome the higher costs. While index funds and ETFs are valuable building blocks within a portfolio, costs matter. I once read about an S&P 500 Index Fund that had a 0.73% annual expense ratio and a 5.75% sales load. I have seen far too many index funds with silly-high expense ratios.
EH: The annual expense ratio on Vanguard’s S&P 500 Index Fund is 0.04%. That would mean an investor in the higher cost fund would under-perform Vanguard by almost 0.70% per year and that’s after they paid that commission up-front. That type of advisor behavior hurts my head. ST: It sounds like costs should be the third piece to our passive definition. That means portfolio construction, manager behavior, and lower costs are all requisite elements to being passive. Q: Why does this active-passive distinction matter?
WJ: Investors need the right focus. Active investing requires finding, accessing, and retaining outperformance-generating managers. A large body of evidence shows that each of those steps is costly and unlikely. In many cases, the industry asks us to ignore the evidence and keep investing based on hope. Outperformance is elusive, ephemeral, and expensive. In contrast, fees, taxes, and inflation are certain. Generating sufficient returns to meet their goals—after fees, taxes, and inflation—is an investors’ proper focus. Intelligent choices on the active-passive spectrum help in reaching those goals.
ST: The merits of active and passive management have been debated since the 1970s when John Bogle started the first index-based fund. Both sides assert their strategy is superior, making it difficult for investors when selecting managers. The evolution of the conversation is important to help clarify the drawbacks and advantages of the two options and where such strategies may be appropriate. Vanguard has fought an uphill battle since its founding but they have data on their side. The evidence suggests that active managers struggle to outperform their benchmarks net of fees, not to mention after taxes.
WJ: A perfect illustration of the tension between Vanguard and Wall Street is Warren Buffet’s Hedge Fund Bet. As you two know, in 2007, he made a $1 million bet, with the proceeds going to charity, that Vanguard’s S&P 500 Index Fund would outperform a basket of hedge funds selected by a hedge fund manager. The bet ends this year and the S&P 500 will win in a landslide. The hedgie has already conceded.
ST: And the results would be even more extreme if we considered taxes.
EH: Whether you call an approach active or passive, we have to respect the evidence that lower-cost, more tax-efficient solutions tilt the odds in the investor’s favor. While there is nothing systematically preventing active managers from being cheaper or more tax-efficient, as a group they haven’t been either. There are trillions of dollars at stake in this debate and the higher costs associated with active management means Wall Street has a vested interest in trying to justify more expensive approaches. I sleep well at night knowing we put our clients’ interests first. Caveat emptor.