Sometimes motions happen so gradually you can barely tell they are happening. As my late great blacktopping brother Paul would say about a worker that he thought wasn’t working very hard; “I had to line him up against a picket fence just to see if he was moving”. This month I want to talk about one of those slow-moving trends that frankly has revolutionized the financial industry…but it took a long time. I’m speaking here about the movement away from ‘actively-managed’ funds to ‘passively-managed’ funds.
Before I give you the fascinating active / passive history in two tidbits of current facts, we need to be clear on our definitions first;
- Active Management; This investment philosophy is focused on buying the right security (stock or bond) at the right time, or conversely, selling that security because you know something that your competing sellers / buyers do not. At other times, it can also be represented by market timing, which is a hands-on investment manager decision to sell most of what is managed (or everything) because markets are going down or alternatively, buy them because you know the market is going up.
- Passive Management; An investment philosophy that eschews the above ‘active’ approach and believes that there is no ‘unique’ insight that an investment manager possesses. Rather than trying to find the needle in the haystack, one would be wise simply to buy the haystack. This approach adheres more to the Efficient Market Hypothesis (EMH – Eugene Fama (1970)) that all the information about a security is known in the market and incorporated into its price.
Some day in the future, I’ll give an outline on the development of the investment industry (which is fascinating all by itself) but suffice it to say that all investment in the beginning was done through active management, with the first investment fund in the United States occurring in 1924 with the MFS Massachusetts Investors’ Trust in Boston (though it was a closed-end fund until 1928 when outside investors could come in[i] – I know what you are thinking; great timing, right?). Though it started slow, active management was the only way an investor could go for almost 60 years and thousands of active funds were formed. 100% of all investor money went that way accordingly. The passive management industry didn’t actually start until 1971 when John (Mac) Mcquown and his crew at Wells Fargo privately created one for Samsonite Corporation for their Denver-based pension plan. John Bogle brought the first publicly available passive fund to market with the Vanguard Group that he founded on that principle in 1976. Passive funds are now commonly referred to as ‘index funds’ because their passive construction seeks to mimic some index.
Given that history, you have to admit the ‘active’ approach sounds far smarter and more appealing. Who WOULDN’T want to buy before something goes up or to sell before a stock crashes? But….do the facts support these aspirations? The answer is no, and it is pretty soundly no. Here’s the promised two tidbits;
- Though competition has continuously reduced the price of actively-managed funds (their Annual Investment Expense, or AIE), the cost reduction has not been enough to offset the additional costs of trading and finding winners sufficient to beat their comparable index fund. The financial services industry publishes something called SPIVA, which is a graphical representation of how actively managed funds perform visa vi their benchmark indices over 5-year rolling periods. It’s a ‘failure’ chart, showing how the active funds performed against their respective institutional asset class index (thus the term, Standard and Poor’s Index Versus Active, or SPIVA). It’s been published semi-annually for over 20 years (most recent one is attached). The conclusion is that active funds consistently fall short of the performance investors are due 59%-73% of the time (at 20-years, the failure rate exceeds 80%). The marketing materials they publish are colorful and enticing and the managers certainly get paid well, but the average investor is falling short of what they deserve the majority of the time (dominant in every case).
- The above reality has not been kept a secret, particularly in this world and time of ever-expanding communications. The observed result is increasingly the money that is currently invested in actively managed funds has dropped from 100%, to 95%, to 90%….and has now just hit a milestone by dropping under 50% of all invested money. As of the end of calendar 2023, passively managed funds along with exchange traded funds (ETF’s, a form of passive type investing) were $13.29 Trillion with $13.23 Trillion in active assets[ii]. Truth be told $13.23 Trillion is still a lot of money taking on more risk and getting less in returns, but the trends are clear. If you have friends or children in active management, you should probably share with them that they might be making someone rich, but it isn’t them.
Beyond the investments themselves, there are unfortunately many (39) behavioral investment mistakes that individual investors make. However, if you control yourself on emotions (overconfidence, familiarity bias, fear, greed, procrastination, etc.), you would still desire to have great investments to make it worth your while. It has taken roughly 50-years, but the trend line away from active management is unceasing.
To be clear, with me you have a portfolio of passive investments, but it is not a straight index. Better even yet, the underlying funds don’t fall short of their respective asset class benchmark, but instead go the other way and actually outperform that benchmark 64%-84%[iii] of the time over multiple time periods. You have to do a lot of little things well to make that happen…but you have them and that discipline is working to your advantage.
It remains my deep and distinct honor to serve you well.
Patrick Zumbusch
Founder and CEO
[i] “A Brief History Of The Mutual Fund” (James McWhinney, Investopedia, February 11, 2024)
[ii] “Passive Investing Rules Wall Street Now, Topping Actively Managed Assets In Stock, Bond and Other Funds” (Jeff Cox, CNBC.com, January 18, 2024)
[iii] “Dimensional vs. The Industry” (Dimensional Fund Advisors, March 31, 2024)
