Penny Wise or Pound Foolish?

In 1976, Jack Boggle launched the First Index Investment Trust. Ever since, the public has been learning just how important fees and portfolio running costs really are. In the 90’s ETFs broadened access to and the appeal of low-cost index strategies. Fast forward to today and it seems almost miraculous that a normal Main Street investor can have access to the S&P for just a couple of basis points. This is without a doubt, something to celebrate.

It’s hard to argue with the wisdom of keeping a lid on fees. If the average return on stocks were something like 7% nominal, then a 1% fee on a traditional actively managed equity fund would be expected to eat up nearly a third of gains over 30 years, assuming the fund manager generates no excess return. That’s massive. In light of this major headwind, perhaps it shouldn’t surprise that most active fund managers fail to beat their benchmark over the long term. If you want to survey the wreckage in person, check out S&P’s SPIVA score cards.

Considering the evidence, we don’t blame anyone for preferring passive. For that reason, at NextStep we believe all advisors should consider offering at least a few portfolios based primarily on passive funds. Yet, it’s probably a mistake to go all passive. Consider the following:

1. Active management is not always about out-performance. Sometimes it’s about safely accessing a niche asset class or providing a customized exposure unavailable in a passive form. Certain asset classes and strategies simply don’t lend themselves to a cap-weighted index scheme. Take, for instance, less liquid emerging market or “frontier” market stocks. In those spaces, a cap-weighted approach simply won’t generate a well-diversified exposure. In fixed income, cap-weighted indexes lead you to hold a portfolio that emphasizes exposure to the most indebted bond issuers – something that seems counterintuitive, at best.

2. Cap-weighted investment strategies sometimes amount to systematically buying high and selling low. At the time of this writing, a handful of mega-caps dominate the US equity market, to a degree not seen for decades. These stocks are “big”, in part, because of high P/E multiples. High multiple stocks are often over-represented in cap-weighted indexes. Should this really be most investors’ default allocation?

Additionally, the performance question is more nuanced than sometimes portrayed. True, passive funds have been systematically outperforming most active stock pickers for a long while now. It would be foolhardy to call time on that now. However, we believe that there is evidence that in the long run, passive investment strategies may be creating their own headwinds. If so, the scale may be slowly tipping back towards active managers. We note that:

1. Costs for active management are falling. According to Morningstar, the average (asset-weighted) actively managed mutual fund expense ratio has fallen by about 38% since 2000.(1) In some categories, the difference in cost between the I-share class on an active fund and the equivalent ETF is now very slight. The advent of ‘active ETFs’ may bring the cost differential down even further, while also reducing less visible costs to active managers such as cash-drag and tax-drag.

2. Competition for alpha is declining. As active managers continue to lose market share to passive investment strategies, the share of investor money attempting to identify and exploit mispriced stocks is declining. This could mean more alpha to go around for the active stock pickers who are left. Today, we’re seeing valuation dispersion at its highest level since at least 1996.(2) This seems to back up the idea that passives may be creating distortions. If so, these anomalies represent an opportunity for active managers going forward.

In light of all of this, what’s the right approach for an advisor aiming to deliver the best possible results for clients? At NextStep we believe that advisors should take an agnostic, open-architecture approach, choosing passive, active or hybrid strategies, depending on the specific application. Some categories positively beg for a passive solution. Others, not so much. There’s no need to be dogmatic about these things.

Of course, sometimes a client may arrive at your practice with firmly entrenched preferences for passive or active. Some clients wrongly view a passive portfolio as one where the advisor has no scope to add value. Other clients see actively managed mutual funds as just another unscrupulous fee grab. In these cases it makes sense to accommodate the client and offer a portfolio that expresses a ‘bias’ towards passive or active funds in their portfolio.

Whatever the ultimate composition of the portfolio, the client will appreciate being educated about how the advisor weighs up the advantages and disadvantages of active funds on their behalf. In addition to helping you offer portfolios of multiple ‘flavors’, NextStep can help you consider how to conduct these important, trust-building conversations.

(1) “How Low Can Fees Go”, August 24th, 2021, Ben Johnson, CFA

(2) According to JPMorgan’s Guide to the Markets, November 2021, the spread between the 80th percentile of stocks and the 20th percentile (by P/E multiple) is now 20.8x versus a long term average of 11.3.

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The information and opinions expressed herein are for general information and educational purposes, and may change at any time. They do not constitute investment advice and are not a solicitation for the purchase or sale of any security or implementation of any specific investment strategy.