Passive investing or active?

The words passive and active carry a lot of baggage in today’s society. When you hear the word passive, what comes to mind? For most people, it describes someone who allows things to happen or accepts what other people do or decide. Active is pretty much the exact opposite, its someone that takes charge or is in control. Everyone wants to be seen as ‘active’; they’re taking charge and making things happen. Passive is almost a derogatory term these days.

 

Applying that type of thinking to investing is where we start to run into problems.

 

Buying index funds is the textbook definition of passive investing: you’re just going along with what the market is doing.  Your return is whatever the market’s return is, minus a small fee.  Index funds generally don’t require a lot of effort, other than making sure you cover the major asset classes and then rebalance once a year (or using a predefined rule).  Because the amount of effort needed is low, your costs are low, both in terms of time spent and fees paid.

 

Active investing can best be described as stock picking.  Instead of buying a prepackaged investment like an index fund, you actively pick the stocks that you are going to invest in and then buy and sell them whenever you want.  Because the amount of effort needed is much higher, your costs are higher both in terms of time spent and fees paid.

 

Following the crowd has its advantages

A lot of advertisers are concerned with making sure you buy things that will help you stand out from the crowd.  So why wouldn’t you want to stand out from the crowd when you invest?  If you buy an index fund, you are keeping your fees very low, but you’re following the herd.  Since most index funds are designed to track a stock or bond index, the chances of outperforming are extremely low.  Everyone wants to think they are great investors and don’t want to ‘settle’ for the stock market average.  Unfortunately, very few investors have the time or the discipline to stick with a strategy over the long term.  They always want to try something new and abandon their existing strategy when its performance is less than expected, as happens to all strategies from time to time.

 

So if passive investing will likely never outperform the market, then active investing must be the answer if you want to outperform?  Well, no.

Standard and Poor’s (S&P) is the largest provider of investment indexes in the world.  Every year they provide performance reports on how actively managed mutual funds have performed compared to their benchmarks.  Unfortunately, most actively managed funds do not have a good track record of beating their benchmarks.  Since it is relatively easy to have a great year, we focused instead on the 5 year periods since S&P began producing these reports for Canada in 2004.  As you can see below, active funds haven’t done well.

 

Canadian Equity Funds	Only 17% of funds outperformed
Canadian Small Cap Equity Funds	Only 37% of funds outperformed
Canadian Dividend Funds	Only 5% of funds outperformed (since 2007)
US Equity Funds	Only 12% of funds outperformed
International Equity Funds (no Canadian exposure)	Only 12% of funds outperformed (since 2007)
Global Equity Funds (some Canadian exposure)	Only 12% of funds outperformed (since 2007)

 

Those statistics above are only for funds managed by Canadian managers, but each market that S&P looks at shows a similar and in some cases a much worse picture.  In the 5 years ended December 2015, only 16% of US large cap funds outperformed the S&P500.  In Europe, only 19% of European equity funds outperformed the S&P Europe 350.  In the Netherlands, no funds outperformed their index over the last 5 years.

 

Yes, you might get lucky and pick one of those funds that did outperform, but you won’t know for sure until after 5 years has passed.  Over that time you would be paying the higher fees that come with active management without knowing whether you will get what you have been paying for.

 

That is why passive index investing is becoming more and more popular.  You know what you are getting up front: the index’s return at a low cost, and that is why ModernAdvisor recommends its clients invest in passively managed exchange traded funds (ETFs) that track broad market indexes.

 

 

So ModernAdvisor is a passive investing manager then?

Not exactly.  At ModernAdvisor, we combine active and passive investing.  To keep your costs (and ours) low we don’t pick stocks, we use ETFs that track broad market indexes to make sure that you have well diversified investments representing the asset classes in your portfolio.

 

The active part of our process is the asset allocation.  Every quarter we look at the expected returns on the asset classes in our portfolios and run simulations to arrive at the optimal asset allocation for each level of risk.  Since these are long term expected returns (10 years), they often don’t change much from quarter to quarter, so we typically only change the asset allocations once per year.

 

A major benefit of revisiting the asset allocation on a regular basis is it increases the likelihood of buying and selling the investments in your portfolio at the right time, even when you may be scared to do so.  If your investment in a mutual fund invested in the stock market was down -20% or -30%, would you want to increase your allocation to stocks by selling bonds?  If you’re like most people, you would probably want to do the opposite: sell your stocks for the relative safety of bonds. But buying more stocks when they are down -20% or more has historically been a very smart move.

 

We looked at the S&P/TSX Composite Total Return Index monthly returns since 1956 and calculated its largest drops.  We found only 1 instance where investing when the index was down at least -20% did not produce a positive return, and in most cases it produced a double digit gain.

 

Invest on:	When TSX is down:	Gain in 1 year:
October 31, 1957	-24.9%	+24.7%
May 31, 1970	-24.2%	+22.7%
May 31, 1974	-20.8%	+5.1%
October 31, 1975	-23.2%	+11.1%
November 30, 1976	-20.4%	+16.7%
October 31, 1981	-21.0%	+1.4%
October 31, 1987	-24.5%	+16.4%
October 31, 1990	-20.1%	+18.6%
August 31, 1998	-27.5%	+28.1%
November 30, 2000	-21.4%	-11.3%
October 31, 2008	-32.8%	+15.7%

 

So while rebalancing your portfolio can help you capture some of that performance, revisiting your asset allocation on a regular basis will ensure that you are buying when markets are undervalued.