The increasing ubiquity of information, a rising presence of computers and institutions in the markets, and an increasing proliferation of index-based ETF products has created a difficult environment for high-priced active managers to outperform. The last decade has also seen the S&P 500 outperform almost every other index, including previously high-flying hedge funds.
Does that mean passive investing is the right approach for investors seeking returns? Not so, according to one active-investing advocate.
In a piece written for Institutional Investor, Ted Seides, managing partner and advisor at Hidden Brook Investments, shared a conversation he had with Greenwich Associates founder Charley Ellis. Their topic: whether active management presents a benefit for most people.
“We agreed on the importance of low-cost investing, but struggled to find common ground from there,” Seides said. While Ellis thought investors should simply leave the work of price discovery to the many intelligent competitors and computers, Seides countered that the many index-based options available today create a “paradox of choice” that makes index selection more difficult than ever.
Noting that the phrase “passive management” could create a bad impression for investors, Ellis suggested “investing in indexes” as an alternative term. But Seides countered by asking if investing in a particular index is the same as investing in “the market,” given the increasingly confusing investment landscape.
Seides said: “Is the S&P 500 equivalent to ‘the market,’ or is owning an S&P 500 index fund an active decision to favor large, US companies over a broader, globally diversified portfolio in a geographically interconnected world?”
And while long-cited academic research suggests that factors such as value, momentum, and yield can be indexed at low cost and have the potential to outperform the S&P 500 over time, value and size factors have underperformed the market over the last ten to 15 years. Seides noted that it doesn’t conclusively prove passive ownership of US equities is better, as the factor-based indexes may simply be facing cyclical punishment in the medium-term environment.
When considering investments outside of large-cap US stocks, he added, arguments for passive management start to ring hollow. Emerging-market indexes, dominated by only a few companies, often do not represent the whole economic opportunity set, and investors who invest in indexes reflecting specific investment themes are engaging in a practice that “is far more active than passive.”
“The passive 60/40 stock-bond strategy has been a high-performing winner for a decade but may not be priced to produce returns that meet spending needs in the next decade,” Seides added. He cited a mid-year review by Vanguard, which said that passive exposures won’t deliver returns like they have in the recent past.
“Any investor should be focused on achieving desired outcomes at a low cost, but conflating low cost with passive management is as out-of-date as paying an eighth spread and 25 cents a share to trade stocks,” Seides wrote.
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