In the last two decades, investors have debated for the merits of both passive and active portfolio management. Both styles of asset management have their benefits and drawbacks; however, recently more and more investors have turned to a passive management style due to fee concerns and risk concerns as well. In order to examine the two investment styles and make a determination on which one can work better for you, let’s break down passive and active management.
You may have heard passive management referred to as indexing or indexed management and those two terms describe passive management in the simplest way. The passive investment thesis is based on the diversity of market indices. Portfolio managers claim that it is either impossible to consistently beat the market or that you take on unnecessary risk in trying to beat the market. Many investors are attracted to indexed investing due to their low costs and fees. Since managers are not actively trading they do not require the same fee an active manager would charge. Additionally, the Mutual Fund or Exchange Traded Fund (ETF) will not require a large fee due to the low turnover of market indices. The name passive comes from portfolio managers basically replicating the movements of a major index rather than responding to business cycle trends or macroeconomic events. Therefore, indexed funds should track their respective benchmark almost perfectly, replicating their upside as well as their downside. The four most common indices used are the S&P500, the Dow Jones Industrial, the NASDAQ, and the MSCI.
Investors who employ an active management strategy often use portfolio managers, financial advisors, or brokers to buy and sell stocks or ETFs to beat their benchmark fund. The basic thesis of actively managed investing is based on research and forecasting. Fund managers will use indicators, economic data, firm-specific data, and other financial data to select stocks or ETFs that they believe will outperform the overall market. This data is used to time the market for buying and selling opportunities that maximize their return. Naturally, the turnover and active style produces higher fees and costs, but managers often only consider net returns when comparing to a benchmark. Almost all hedge funds employ active management strategies and they also charge high management and performance fees. However, due to the increase in popularity for ETFs some advisors are looking to allocate growth funds to actively managed portfolios. When long-short equities were the dominant actively managed investment style it was difficult to diversify and protect from disastrous downside during an economic recession. However, ETFs provide diversity that can limit downside but give you near the same upside that individual equities can provide.
Here at Nicholas Wealth Management, we believe the key to beating the market over time lies not in the upside but in limiting your downside risk. Passive management can work but it may not be the most efficient way to grow your money safely. With Passive management, you will participate in all the upside and all the downside as well. With recent recessions in 2000 and 2008 causing 40-60% losses in the market it is important to protect your portfolio. To exemplify this point we studied one of the most basic active investment strategies, cyclical and defensive investing. We studied the last twenty years in the stock market and used two ETFs along with the S&P500 as our benchmark. Obviously, nobody ever knows what the market will do but time in the market usually produces excellent returns for a diversified portfolio. But first, what is cyclical and defensive investing?
Cyclical vs Defensive
Cyclical stocks are very highly correlated to economic activity and macroeconomic trends. The companies tend to do very well when the economy is doing well and they tend to struggle if the economy is struggling or in a recession. Recessions cause their profits, cash flow, and revenues to drop and the share price will follow the fundamentals. A great example is the automotive industry. The chart below from Societe Generale illustrates the automotive stocks following the business cycle in their year over year returns. Where the grey periods are times of recession.
The beverages sector is the exact opposite and is part of the defensive stocks category. Defensive stocks belong to sectors that are less vulnerable to an economic downturn. Examples would be food, utilities, healthcare, and non-durable goods. When the economy is doing poorly consumers will not buy less soap or toothpaste because they are essential items so companies that operate in these categories normally will not suffer as much as cyclical companies. This is illustrated above as the downside of the beverage sector is not as great as the automobile sector. However, the upside of defensive stocks will not be as high as the upside for cyclical stocks is.
To illustrate the potential reward of active management we took the return data for XLP (Consumer Staples ETF), XLY (Consumer Discretionary ETF), and S&P500. Our data timeline is from 1999 to 2018. In those 20 years the defensive ETF, XLP, had a maximum yearly downside of 20% and an average return of 4.02%. The cyclical ETF, XLY, had a maximum yearly downside of 34% and an average return of 8.67%. Finally, the S&P500 had a maximum downside of 38% and an average return of 4.9%.
To illustrate the benefits of active investing we took a portfolio that needed to allocate 100k to growth and invested it passively in the S&P500 and the two ETFs. We also created an actively managed cyclical and defensive portfolio that used the cyclical ETF during economic booms and went defensive during recessions limiting the downside risk. The results are illustrated in the chart below.
Not only did we find that the mixed portfolio exceeded the market, but we also found that it had a higher risk-adjusted return. So investors would’ve taken on less risk to get a much higher return. Hindsight is 20-20 but the main benefit of active management comes from advisors and portfolio managers that try to limit downside as much as possible. If you beat the market in the downturns it becomes easier to consistently beat the market over time. Active management is not for everyone and it comes down to trust. Investors have to trust the advisor or portfolio manager they hire to protect their assets and give them the return they desire. For conservative investors that prefer passive management its important to make sure your advisor is not charging you a fee to do something, you could be doing yourself. If investors just want to index their funds there is not a large need for an advisor to collect commissions and fees to do it for them. Often the same funds and fees advisors use are available on low cost investing platforms that can save you thousands. The debate between active and passive management will continue to rage on but the question should not be which style is better. The question should be which style is best for you.