In Chinese philosophy, yin and yang describe how seemingly opposite or contrary forces may actually be complementary, interconnected and interdependent in the natural world. When you look at portfolio management, passive (indexing) and active strategies are the yin and yang of investing.
However, most of the debate around passive versus active investing comes from those advocating for one approach over the other.
We, on the other hand, believe they are complementary and not mutually exclusive. Based on our research, neither an all-passive, nor all-active portfolio, is an optimized portfolio. Rather, optimal appears somewhere in the middle, hence our comparison to yin and yang.
The Case for Passive
- Narrow-Based Market
For many years, the S&P 500 performance has been driven by a small number of stocks. Portfolios that do not own a handful of these stellar performing stocks will underperform. In years where the S&P 500’s total return is between three and 11 percent, a few select stocks drive the market’s return.
The median number of stocks driving the market is 10. So far, this year is no different. The S&P 500 is up seven percent, and 12 stocks are dominating performance.
When the market is narrow-based, including passive investments in a portfolio is clearly beneficial.
Passive funds simply replicate an index like the S&P 500 or the Russell 2000 and have lower management fees than actively managed funds. Fees negatively impact a fund’s performance, and over the years there has been downward pressure on management fees on both passive and active managers.
Remember, though, fees should be part of the investment process, not drive the investment process. Is the least expensive automobile the right one for you and your family? Perhaps not.
3. Efficient Markets
There is an academic theory called the efficient market hypothesis (EMH) that suggests it is impossible to beat the market. If the market is efficient, share prices reflect all relevant information and trade at fair value; therefore, active managers can’t outperform the market.
I would counter that some markets are efficient and others are far from it. For example, from 2009 to 2016, 80 percent of domestic, large capitalization managers underperformed the S&P 500, suggesting it is efficient. However, in the same period, 60 percent of domestic small capitalization managers beat the Russell 2000, suggesting it is inefficient.
The jury is still out on EMH. However, it is clear that some markets and asset classes are more efficient than others, once again supporting the yin and yang case of using both active and passive investments in your portfolio.
The Case for Active
The narrow-based market argument suggested that, at times, a few stocks drive the market. This year is no different. The top 10 performing stocks year-to-date trade at 3.4 times sales. The S&P 500 trades at 2.5 times sales, and the bottom 490 stocks in the index trade at 1.9 times sales.
However, we believe that over entire market cycles, valuation matters. Historically, sooner or later, overvalued stocks underperform and undervalued stocks outperform.
Most active managers attempt to buy undervalued stocks. By doing this, they can control risk and perform well over a market cycle.
If the index was dissected into high-quality stocks (rated A+ to B+) and low-quality stocks (rated below B), as defined by Standard and Poor’s, it would show they perform differently at various times.
Low-quality stocks outperform during the early stages of a cyclical bull market, while high-quality stocks perform best in a bear market. Of course the index owns both high- and low-quality names.
When safety trumps valuation, high-quality names will protect the portfolio. Thirty-one percent of the companies in the Russell 2000 index lost money last year, while high-quality stocks have not experienced negative returns over any 10-year period since 1986. Typically, active managers search for quality investments.
Dividends play two important roles. First, they can be a material factor in total return. If stock prices appreciate five percent and there is a three percent dividend yield, the total return is eight percent. Importantly, 37.5 percent of the total return came from dividends.
Second, as companies pay and increase dividends, it sends a message that management is confident that earnings will increase. Since 1972, stocks that increase or initiate their dividend have outperformed the market by 2.6 times. During this period, dividend growers and initiators returned 10 percent annually versus the S&P 500’s 7.6 percent.
Active managers can build portfolios that seek out stocks with attractive and growing dividends.
All Investing is Active
Portfolio management requires numerous decisions. Asset allocation is paramount—which asset classes should be in the portfolio, and what allocation? Even if passive securities are to be used, which index is appropriate?
For example, the 2016 return for three passive small capitalization exchange traded funds, each with their own underlying index, had an eight percent return variance:
• iShares Core S&P Small Cap, 26 percent return
• iShares Russell 2000, 21 percent return
• Vanguard Small Cap ETF, 18 percent return
Every component of portfolio management requires a well thought-out and researched decision. Thus, all investing is active.
The Yin and Yang
Passive and active management styles are not opposite or contrary; they are complementary. Given our research, we believe using both styles strategically in portfolio management creates an equilibrium and holistic strategy.
KC Mathews is UMB’s chief investment officer.