The debate between the relative merits of active and passive strategies has waged for some time now. Often, it is waged with journalists and academics taking the passive side and advisors taking the active side. Now, as pretty much everyone knows, neither side has been able to score an unchallenged victory. Given that this is the case, what should a STANDUP Advisor (i.e. one who is committed to scientific testing and full disclosure) say to clients?
To begin, the advisor could (and likely ought to) be clear to their clients that there is no single, definitive right answer to the question. Regulators have gone on and on about their commitment to disclosure, but have done little to force this debate into the open. Why not demonstrate a commitment to full, true and plain disclosure by explaining to clients that there are pros and cons to both approaches?
There are obviously risks in both approaches. Still, the framing that I hear from many of my colleagues is not always balanced, in my opinion.
Over the years, I have heard numerous product suppliers and fellow advisors tell me that active management outperforms passive in down markets, as if it was unequivocally correct.
Yet, recent evidence, released by Standard and Poor’s, suggests otherwise. Every quarter, S&P releases quarterly scorecards where passive and active management are compared and contrasted. Called the Standard and Poor’s Index Versus Active (SPIVA) report, it is used to compare and contrast the quarterly earnings of managers in both disciplines. SPIVA even includes a special report that examines the Canadian bear market from August 2000 to December 2002.
According to SPIVA, only a minority – 38.9% of active Canadian Equity Funds – outperformed the S&P/TSX Capped Composite Index during that period. The rest lagged.
It is my impression that those who favour active strategies might not be particularly forthcoming about this research (or similar research) that contradicts their primary value proposition of reliable outperformance through security selection and/or market timing, when discussing investment options with their clients.
These advisors may point out that an investor is virtually guaranteed to lag a benchmark, since passive products cost money, too – even though they make no attempt to add alpha along the way. This is undeniably true if one uses a simple market capitalization weighting passive approach (there are others). It is also true that people who utilize passive approaches are highly unlikely to underperform by much more than their costs, which are roughly a half (income products) to a third (equity products) of the cost of active alternatives. Meanwhile, experts in behavioural finance suggest that the pain of a loss is more than twice as strong as the joy of a gain.
My sense, though, is that real client-centric advisors are inquisitive about robust research and try their level best to bring the best products and strategies to their clients. And the best are at least aware of the SPIVA reports’ findings (read the reports at www.spiva.standardandpoors. com). If you’re really bold, why not go to http://www.stanford.edu/~wfsharpe/art/active/active.htm to download an article by William F. Sharpe, where he shows the logic that demonstrates how the average actively managed product must underperform the average passively managed product. One step further, and you can encourage your clients to read these papers, too.
There are almost always exceptions to the general rules found in both papers. But wouldn’t it be great if clients understood the chances they were taking before they took them?