Are active or passive investment strategies best? Josh Brown at The Reformed Broker writes there are both smart and stupid arguments to be made for active management:
Marketocracy’s Ken Kam, who has spent a career studying and vetting active managers, touches on one of each type in an interview with Covestor the other day.
First, his smart argument, the thing about all strategies that is always true:
“My experience has taught me two important lessons. One, there is no sector or investment style that works all the time. And two: a great manager gets that way by honing his skill in a single sector or style. The combination of these two lessons is that if you want good performance over time, you can’t get it by using the same managers year after year.
My approach is to look among the managers who have proven themselves over the long term to find those whose style is performing well now. If there are a lot of proven managers who are all performing well now, then I choose managers whose styles are different from one another, to reduce the impact of any single manager’s style falling out of favor.”
This is absolutely correct, there is no strategy – be it active, passive, value, growth, long-short, arbitrage, mean reversion, trend-following, stock picking etc – that will always work in all environments. Kam gets this correct. The trouble is, most passive guys say they don’t care about this or that style being out of favor, they will wait ’til the cycle swings back around – “Forget the needle, buy the haystack” Jack Bogle exhorts us. Most active guys, on the other hand, will be the last to recognize (or admit) that their expertise is not beneficial in a particular market moment.
Kam’s other argument is of the “stupid” variety. Please understand that this is a very smart man making it, so no insult intended:
“Owning an index fund is like being a passenger on a jet on automatic pilot. Today’s automatic pilots are so good that one might argue that having a human pilot on board is an unnecessary expense. But would you be willing to fly on jet without a human pilot on board? Perhaps if the sky is clear you might consider it. But certainly not if you thought you might be flying into a storm.
I think index funds make sense for those who see clear skies ahead for the stock market. For those who see a storm coming, having a human pilot at the helm makes a lot more sense.”
Okay, I’m gonna stop you right there.
The passive investor absolutely does not see “clear skies ahead” at all times. Rather, this investor recognizes that most managers will not be able to detect and react to the thunderclouds in a timely, consistent way. In addition, many of them will be so hyperactive that every gray cloud will appear to be a hurricane, and so a lot of buying and selling (churn) will be the result – leading to higher taxes, trading costs and potential for missed opportunities.
While Josh does not take sides, professing that he is ambivalent about whether active or passive management is preferable, he says in the past five years passive has outperformed active investing.
I agree with Kam and Brown that no investment style works all the time. But I disagree that index funds out-perform in a bull market, when there are “clear skies ahead”. Active investors using momentum or trend-following strategies will comfortably out-perform the index. But, as Brown points out, most active investors fail to react to an approaching “thunderstorm” and will get caught in the ensuing bear market. Holding fast-moving stocks, they then under-perform the index, with sharp falls and severe capital draw-downs. And in the uncertainty that follows, like 2010 to 2012, active investors will also under-perform: with no strong trend there are too many false starts.
My conclusion is that active strategies out-perform in a bull market, while passive strategies are more resilient when there is no strong trend. Neither do well in a bear market, but passive strategies incur relatively less damage. Using technical indicators to identify the start and end of bull markets may seem the obvious solution, but can lead to false signals and expensive “churn”. A thorough understanding of macroeconomic indicators is essential to confirm market signals, but this can take years of study and is not for the faint-hearted. At all costs, do not try to make forecasts; even professional economists seldom get this right. Simply use the indicators to identify market risk and adjust your strategy accordingly.