January 1st of 2008 commenced one of the most exciting bets of this century (at least to us finance nerds 😊). “The Bet” pitted Warren Buffet, arguably the world’s most successful investor against Protégé Partners LLC, a hedge fund based out of New York City. Buffet believed that the fees associated with the active management of the hedge fund could not be justified, and a simple low-cost S&P 500 Index would outperform (when adjusted for fees) over a 10-year period. This is the active vs. passive investment debate at it’s finest.
Several factors contributed to making this wager so fascinating, but at its core, “The Bet” sought to settle the age-old debate of active versus passive investing. Considering the title of this blog is Why Active Investing Isn’t Worth It, you can probably determine for yourself who won, but I think a deeper dive into the how and the why along with some supporting data can really help to shine some light on this issue.
Defining our Terms: Active vs. Passive Investing
For the purposes of this post, active investment management refers to a more hands-on approach in which the investment manager buys and sells securities in an attempt to outperform the market. Passive management can be defined as a portfolio mirroring different sectors of the overall market. In other words, passive investing attempts to return what the greater market returns and active management attempts to beat what the overall market is returning.
Back to “The Bet”
As I stated before “The Bet” began at the beginning of 2008. Many reading this certainly remember the 2008 stock market crash! For Buffet and his passive management strategy this was worst case scenario because hedging (limiting losses) is a hedge funds specialty…go figure.
Year one ended with Buffet’s index fund losing 37% of its value while the hedge fund fared quite a bit better only losing 24% of its value. However, the tides turned quickly as this kicked off a period in which Buffet’s index fund beat the hedge fund in 8 of the next 9 years. In the end, it was a considerable defeat for Protégé Partners LLC, as their fund returned 22% while the S&P 500 Index Fund returned 85.4%.
Luck or Science
While this certainly gives us a nice anecdotal story to highlight the benefits of passive investing, could it simply be the case that one of the most intelligent investors of all time outsmarted the hedge funds at their own game? Maybe…but I don’t think so.
Warren Buffet is incredibly shrewd and has proven to be successful investing over several decades, so it is certainly reasonable to believe that he simply snuffed out the market conditions in the upcoming decade better than this hedge fund. However, when evaluated with a larger lens, this looks less like ‘Oracle of Omaha’ magic and simply fits into the big picture that the body of data lays out for us.
The Real Reason We Believe in Passive vs. Active Investing: SPIVA
No SPIVA isn’t a sweetener that you put in your coffee…SPIVA stands for S&P Indices Versus Active. Ultimately this is a research metric which measures the performance of actively managed funds against their index benchmarks. Paraphrased for the less financially inclined, this data looks at mutual funds whose managers make active decisions regarding the fund’s holdings and market timing strategies and compares them to the greater market in that category.
The data is incredibly convincing. Nearly 90% of actively managed large cap funds underperform the S & P 500 when adjusted for fees over a 10- or 15-year period. The fact that this data is up to date as of June of 2022 makes this even more compelling as this data contains the lion’s share of the stock market downturn in 2022. This is significant because, historically, actively managed funds perform better during downturns in the market. Last year 55% of actively managed funds underperformed…so in their best showing in over a decade, on average you were still better off being in passively managed funds, and in the last decade only one out of every ten funds outpaced the benchmark.
Look at the SPIVA Data Here: SPIVA | S&P Dow Jones Indices (spglobal.com)
Whether you are a DIYer or you utilize the services of a financial advisor, this may raise several questions about your own investment portfolio.
Why can’t I just pick one of the 10% of active funds that has outperformed its benchmark?
The truth is you can…if you can identify it. While we certainly have back-tested data, mutual funds have very weak, if any, levels of correlation from year to year. In other words, how a fund performs in one year is in no way a predictor of how it will perform in future years. This ultimately leads to the conclusion that trying to choose the fund that will outperform is a fool’s errand.
Undoubtedly, some of the brightest minds in the world show up to work every single day trying to outpace the market, yet they fail nine times out of 10. I certainly don’t have the hubris to place my clients’ hard-earned money into a situation where they under-perform 90% of the time, and I sincerely wonder what the advisors who push active management know that I don’t. Perhaps this is how they justify their fees?
To me this seems to fly in the face of an overwhelming body of evidence pointing to the contrary.
When Active Investing Might Be Worth It
The one big exception to choosing passive instead of active funds is if you are making a choice of active management for reasons other than performance.
What other factors are there? The main alternative factor that clients have expressed is a desire to not inadvertently support companies who violate their values (i.e., a Catholic client who strongly opposes abortion does not want to invest in, or profit from, a pharmaceutical company’s production of an abortifacient drug). This is no doubt a noble pursuit. It is worth recognizing that the act of screening the investments, whether done by a person or technology, does come at a cost, so expect slightly higher fees in this space.
I have a tremendous amount of respect and admiration for those who choose to live with this level of intentionality in their life. We are fortunate to have access to several funds that have faith-based screens for our clients to choose from.
So, what does this mean for the average investor?
Ultimately the conclusion drawn by the average investor should be that actively managed funds do not lead to higher levels of return. While I can certainly understand utilizing a more active strategy to help control the types of companies that you are investing in, I find it difficult to find any other reasons to do so.
If you are currently utilizing a financial planner it is worth it to ask if they are engaging in an active investment management strategy. Managing investments on your own? Look at moving more into passive vs. active investment funds. Can’t tell what kind of investments you are in? Check out our Free Retirement Assessment process where we can help evaluate your current portfolio.
If the data says investments should be passive, why should I hire a financial advisor?
If the only reason you have for hiring a financial advisor is for investment management, then you should put your investments into a simple portfolio of index funds and save the cost it takes to work with a planner. While I plan on creating more content regarding what makes a good financial planner at a later date, I will simply say here that a good planner should be able to work with you on many more things including tax planning, retirement income planning, risk management, estate planning, matching your risk profile with your asset allocation, asset location, and much more.
We believe that the value of working with a financial planner should exceed the cost of doing so. I have seen time and time again that a well-executed financial and retirement plan leads to lower levels of stress and higher levels of happiness.
This post is for educational and entertainment purposes only. Nothing should be construed as investment, tax, or legal advice.