Busting active versus passive myths

Investors these days truly have a tough nut to crack, as much has been debated about the merits of active versus passive management. Amid debates, confusion and reports — investors still need to plan and carefully assess the best way to manage their funds.

At the first Vanguard Investment Strategy Group Investment Forum, principal Fran Kinniry looked at several myths about the relative merits of active and passive management. One myth that he dispelled was that active management will work better in a bear market due to the active involvement of managers collectively knowing when to move into cash or when to become more defensive.

“A lot of things work well in storytelling,” Kinniry told the crowd.

In the last seven bear markets from 1973 to 2008, according to Vanguard data, indices beat actively managed funds in four of those periods, and active managers beat index funds in three. Meanwhile, in the last bear market from October 2007 to December 2008, U.S. indeices beat actively managed U.S. equity funds by 1.4%.

“Coming out of the bear market is also important,” he said. “Active management hasn’t consistently been able to predict a bear market coming on and hasn’t consistently been able to predict when the market would come back.”

However, active management has been winning since the bear market ended in March 2009. While performance improves slightly and some active managers may outperform index funds, it’s over the longer term that costs have a greater impact on mutual fund performance. However, finding the evidence to show consistency with respect to out performance has proven difficult.

Kinniry argues that indexing wins overall and works in all markets. “Indexing does not need an efficient market hypothesis to maintain its value proposition,” he stressed a number of times.

According to Kinniry, the case for indexing has to do with transparency and knowing what you own at any given moment and what your exposures are. “If I am betting on cyclical sectors and commodities, I really want to use an index based on transparency. I want to see what my beta looks like”.

In the late 1990s indexing was doing well, while in the 2000s actively managed funds have generally outperformed the market. According to Vanguard data, between the 2000 to 2003 U.S. bear market 60% of active funds outperformed the U.S. stock market.

“We see a very high degree of cyclicality between index and active leadership and it has nothing to do with whether active managers are more intelligent in this environment or less intelligent in that environment,” Kinniry says, pointing out that it has more to with the methodology, and what we know about the industry.

According to Kinniry, this doesn’t mean active managers are smarter or better stock pickers. This also doesn’t mean that it’s a stock picker’s market.

“I would argue very clearly that what is happening here is a large cap rally,” Kinniry says.

The active and passive management arguments have little to do with a bear or a bull market, but whether it’s a large cap market, a small cap market or value market.

In 1999, long-term active managers performed poorly, according to the data presented, with only 31% outperforming the market. Meanwhile, 10 years later a mirror image occurs where long-term active management looks great and 66% have outperformed the market and have been “really kicking the pants off the index,” Kinniry says.

The increase in index ownership when compared to active has been felt— a trend that accelerated mostly in the last five years. Despite the undeperformance of the index funds, they are seeing a much higher proportion of inflows, leaving many actively managed funds in a bind for cash to deploy.

“Index fund has been dominating cash flow. It is active management that has been having a negative cash flow for quite some time,” Kinniry says.

Vanguard has almost as big a stake in active management as in passive: assets are 46% active to 54% indexing.

(10/09/09)