Lots of debate in the investment world centers around the idea of whether indexing is superior to active management. However, the truth, like most things in life is a clear black or white situation. The are benefits to both styles of investing. Rather than argue for or against either one, the most sophisticated money managers in the world (endowment funds, defined benefit pension plans) all use a combination of both strategies. If the people managing these funds use a combination of both active and passive investment strategies, then why is the mainstream media (including pf blogges) wasting our time arguing about this. Rather, let’s take a look a the pros and cons of both investment methods.

The case for indexing

Transparency - Index funds are easy to understand and are transparent. They

Tax Efficient - Because of the low turnover, indexing is more tax efficient.

Low Cost - Pretty Self Explanatory.

No style drift - If you invest in a value ETF or Index Fund, you can be assured that you are 100% invested in a value fund (subject to the definition of value). Contrast this in the late 90s when every value fund had “growth stocks” in them or they risked more underperformance!

Many (but not all) actively managed funds underperformed their respective indexes

Below is a table shown by Vanguard that shows the performance of funds outperformed by their respective indexes.

While indexes outperform many funds, there are certain sectors where active managers have a tougher time beating their respective index. You can see that in the value space, the MSCI value index outperformed more active managers than in blend or growth sectors.

But is this the case for just using indexes in your portfolio. Certainly not. The reason is because the best managers beat in the indexes in certain years while indexes will outperform in other years.

Advantages of Actively Managed Funds

There are Managers who consistently outperforms their Index

This one needs little explanation. In fact, in the world of instituitional investing, only managers who consistently outperform their index will even be considered by instituitional money. Many of these managers have funds that are unfortunately not available to ‘retail investors’ like us. Hence, you see the statistics that the vast majority of managers underform the broad index. In the instituitional world, only managers that outperform their indexes (style index) stay in the game. The truth is that there are many managers who consistently outperform their bench marks.

Allows Superior Risk Adjusted Returns

Studies have shown that a portfolio with identical returns with the S&P500, but with lower risk (ie volatility) will massively outperform the S&P over long periods. This is because during bear markets, portfolios with lower volatility preserve your capital better and hence coming out of a bear market, you are already ahead. An index fund does not allow the opportunity for you to seek better “risk adjusted” returns. You essentially accept market risk.

Exploit anormalies

One of indexing’s main flaw is that if every indexes, then large cap stock tends to get more overvalued. This was certainly what happened in the late 90s. Hence investing indices could result in having ‘overvalued securities’. In fact, studies have shown that overvaluation of securities persist simply because they are included in the indexes. When these securities are removed from the index, valuation returns to ‘industry average’.

Below is a study done by Vanguard on the relative performance of an all index, active managed funds and a passive combination of both active and index funds.

Analysis of Performance of Active, Index and Combination Portfolios

An analysis was done with seven possible portfolio combinations from 1981 to 2005. The total market index consisted of the Wilshire 500 index. There were three active portfolios (call them A, B, C) which were complied by Lipper with the following characteristics. The active portfolios were well diversified combinations of Lipper fund category averages in proportions that approximated the market capitalizations for the broad market. Next, we had a passive 50/50 combinations of the index with each active portfolio.

Results

Let’s see what happens when we use an all index portfolio, active portfolios and a passive 50/50 mix of both active and passive portfolios.

As you can see, a passive combination of active and index portfolio will not gave the best or worst performance in any period. But over a long period, it gives you the equivalent performance of either an all index or all actively managed account but it smoothes out the ride and lowers your volitility.

We can see now that it is pointless to argue over the merits of either strategy over the other. Both have their pros and cons. Combining them in your portfolio is something perhaps we should all consider.

But the proof that both index and active managers have a place in your portfolio can be found in what the largest pension plans are invested in. Below are two articles that will prove this point. The first one highlights the Top 200 Funds with Defined Benefit Indexed Assets. Also check out the growth of index securities among Defined Benefit Plans. These are taken from Pensions and Investments website, the premier website for news on latest news on pension plans and the money management industry.

I hope this post will highlight the fact that there are both pros and cons to index and active management. However, the mainstream media and many pf bloggers tend to favor one against another. The truth is that the smartest and largest money managers in the world utilize both active and passive index strategies. It’s about time we learn from asset allocators rather than listening to “mainstream media”.

This entry was posted on Friday, May 18th, 2007 at 6:51 pm and is filed under Investing, Personal Finance. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.