The Wager: Active vs. Passive
In order to prove investors were better off investing in index funds rather than pay for stock pickers, Warren Buffett famously made a wager in 2008 that the Standard and Poor’s 500 index fund would outperform five funds of hedge funds over the ensuing ten-year period. The Oracle of Omaha won this bet fair and square.
Active managers charge fees to compensate for stock picking efforts, which begs the question: Are investors better off sitting back and investing in a low-cost passive strategy such as exchanged-traded index funds (ETFs)? Or should they consider hiring experienced portfolio managers and stock pickers that are more proactive selecting investments?
So what is a passive investment strategy? It is one that removes human interaction from the process. The most popular form of passive investments are ETFs, which are securities that comprise of an underlying basket of stocks or bonds that often track an underlying index, such as the Standard and Poor’s 500.
Supporters of passive management and index funds can be traced back to the efficient market hypothesis, which has been widely popularized throughout financial academia since Eugene Fama publicized his theories in the 1960s. The efficient market hypothesis asserts the market is efficient, and therefore prices fully reflect all public and private information that could be available to investors, which is another way of saying stock pickers might as well pack up their bags and find a new career. We believe such assertions may prove unfounded, as we discuss further below.
Are ETFs Making Markets Less Efficient? An Opportunity for Stock Pickers
The critical assumption made by the efficient market hypothesis is that all market participants are proactively trying to determine the accurate price of securities given available information. However, these days, over half of the total value of all U.S. equities is passively managed, due to the advent of ETFs, and coincided with the longest bull market in stock market history. We would argue the key assumption to support the efficient market hypothesis has not held up as fewer market participants actively involved in stock selection could in turn make markets less efficient.
According to research firm Coalition Development, there was a 20% decline in equity research analysts at 12 major Wall Street banks from 2012 to 2019. Given the critical assumption to support the efficient market hypothesis above, the continued flight of human touch from the stock selection process could
make the stock market more volatile, and less efficient. This could lead to further opportunities for traditional stock picking.
Active Managers can Mitigate Downside and Capitalize on Market Dislocations to Outperform
Index funds are indifferent to bubbles. The Standard and Poor’s 500 index fund is weighted by market value, so even when valuations reach staggering levels, the index will overweight these stocks. As of the time of this writing, the top 5 stocks in this index – Apple, Microsoft, Amazon, Facebook, and Google – accounted for approximately 23% of the entire index. The Standard and Poor’s 500 index is currently at concentration levels observed in the dot com bubble.
One of the best ways for stock pickers to outperform indices over a long period of time is by being down less in down markets, a metric sometimes referred to as “downside capture.” Active managers can outperform in down markets by avoiding the “losers” that may be indiscriminately held in passive funds, or by holding more cash if stocks seem expensive. To put this in perspective, index funds returned an annualized 7.13% for the 20-years ended November 30, 2017. If the 25 worst performing stocks were excluded from the index, annual returns would have improved to 17.9% over the same period.
Here at FBB Capital Partners, a $1B+ RIA based out of Bethesda, Maryland, we have a team of CFA, CPA, and CFP credentialed personnel that actively seek out investment opportunities for our clients. A large part of the research team’s time is spent speaking with company executives, competitors, suppliers, and other industry specialists to ensure we are focused on the best investment opportunities while minimizing risk. We also put together detailed earnings and valuation models to ensure we buy low and sell high. The deep understanding and high conviction of the stocks we manage on behalf of our clients, as well as the ability to be proactive and deploy cash during the market’s dislocation allowed us to outperform the benchmark during and through the depths of the COVID-19 crash.
Where to go from here?
Overall, while technological advances certainly provide efficiencies in the research process, we believe the human element is an essential component to selecting investments that meet client objectives.
Any readers that are significantly exposed to ETFs or other passive index funds may be well served to seek more active portfolio management, particularly in this current market environment.
-FBB Research Analyst, Zach Weiss, CPA