Has The Era Of Passive Investing Just Come To An End? (Hint: Yes, It Has.)

Posted by Don Garman on July 13, 2015

The debate between active and passive investment management has been regularly discussed in investment circles for the last two decades, and it’s a debate unlikely to go away soon.

Our take is that the rules of the game are in the process of changing in a way that will affect investors for many years to come.

The reason: As interest rates start to rise – which is likely in the next six months (or perhaps much longer) – the investment climate will change dramatically.

As rates climb, it will be harder to make money through investing through “passively managed” indexes.  It’s going to require more analysis and judgment to make a profitable investment decision.  Stock pickers will have to be savvier than they have in the recent past about differentiating and selecting investments based on the company’s fundamentals and future earnings potential.

It’s a time when active portfolio managers will once again prove their worth, at a time when fewer professional investors possess those skills.

At Mirador Capital Partners, the active vs. passive debate is one we relish.  We have a long and proud tradition of successful stock selection as an active manager, and we are well-positioned to execute our strategy in this kind of market environment.  All of our portfolios have been positioned for changes in the direction in rates.

 

Active Vs. Passive

To understand the arguments for and against active management, it’s important to clearly define what they are.

Active management is the process in which a manager or a team of managers use research, forecasts, and their own judgment and experience to decide whether to buy, hold or sell an investment.  Active managers believe they have special insight and expertise to reduce risk or beat the market, which is typically defined as an index, such as the S&P 500 or the Russell 2000.

Passive management is the opposite.  Capital is invested in an established portfolio of securities, such as an index fund or ETF.  Managers have no discretion and do not select the stocks in the index or portfolio.  Passive investors believe that active managers cannot outperform the market over long periods of time.

 

Active Managers Ahead in Early 2015

Active managers actually did outperform the market in the early part of the year.  Not surprisingly, interest rates ticked up during this period.

An April 1 story in Barron’s makes the point even more emphatically.

From 1962 to 1981, when the 10-year Treasury yield more than tripled, from 3.85% to 15.8%, the median cumulative return for large-company mutual funds (including those that have since closed) was more than 62 percentage points better than the S&P 500, or an average of 3.2 percentage points per year. In other words, $10,000 invested in an active fund that earned the median return in that stretch would have $13,000 more than the same investment in an S&P 500 index fund. That lead reached 70 percentage points in 1983, then steadily eroded as interest rates headed down.”   [ Max, Sarah. (2015, April 1). Return of the Stockpickers. Barron's. ]

Over the larger term, research shows that active management generally does better with small-cap, mid-cap, foreign, and intermediate-term bond funds than U.S. large-cap funds. That’s because the market for these asset classes is less efficient. Less is known about them, and therefore sharp investors have an opportunity to spot value where others don’t.

 

Looking Out On The Horizon

What will be interesting to watch is how my colleagues perform in a rising interest rate environment, given the fact that stock picking as an investment discipline has been waning over the past 20 years.

When I first entered in the business, most investment professionals made a living choosing stocks.  They were trained in the art and discipline of stock selection, and those who weren’t adept were quickly weeded out.

Today, stock-picking is a lost art to a whole generation of investment managers who have relied on passive management.  They’ve purchased index funds and other vehicles. We’ll see how good they do now against active managers.

 

The Bottom Line

As someone who loves to sail, I love to use nautical metaphors to illustrate a point, so here goes.

During the past 10 years or so, a strong tailwind was at our back and the market advanced. All boats throttled ahead. Now, we will be facing a headwind for the foreseeable future.  The captains who have sailed in these conditions before are the ones most likely to progress.

Put another way, if you don’t have an “active” portfolio strategy to complement your index-based strategy, you’d be wise to get one!

 

Topics: Active Management

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