Our Approach to Active vs. Passive Investing by Per Lorange
**“Is It Possible to Beat the Market?”**
For many years, investors, analysts, and researchers have wondered whether it is possible to beat the market on a continuous basis. This question is one of the great unresolved mysteries of finance, and it effectively divides the finance community into two camps. If it is possible to beat the market consistently, then it makes sense to actively pursue such an opportunity when investing and managing one´s savings and wealth. If not, the implication is that market returns are perfectly acceptable as such, and that the resulting strategy should be to passively mirror the market through broad ETFs and index trackers.
In this article, we will look at some of the arguments for and against active and passive approaches to wealth management and investing. (In another article, we will look at the arguments for and against keeping investment capabilities in-house or outsourcing them to external managers.)
In the case of active investing, there are many reasons that investors underperform the market, but investment fees are one of the major obstacles to keeping up with the benchmarks. These fees may be commissions and stamp duties or fees charged by active investment managers. An analysis conducted by CEM Benchmarking for the Financial Times compared how pension funds’ portfolios would have performed if passively invested, based on their asset allocation strategy. The analysis showed that the active managers only beat the market by 60 basis points, 44 of which were consumed in costs. With such high fees and so little outperformance, there is little margin for error, and one can easily end up underperforming the market. Passive fund managers, index trackers, and ETFs charge fewer fees than active fund managers.
Despite the higher costs, many investors would be happy to pay more if fund managers consistently achieved a higher return. Unfortunately, the reality is that few active managers beat the market, and even fewer are able to do so on a continuous basis. An analysis conducted by the Economist looked at the best-performing 25% of American equity mutual funds in the 12 months leading up to March 2013 and compared their performance over the subsequent 12 months to that in March 2014. During that time period, only 25.6% of those funds stayed in the top quartile (see chart). That result is no better than chance. In the subsequent 12-month periods, this group went down to 4.1%, 0.5%, and 0.3%—all figures worse than what chance would predict.
This finding does not come as a surprise, however, because of the “iron law of costs”; when professional fund managers, in aggregate, own most of the stock market, their overall performance is highly likely to be similar to the index that tracks the market. However, the index does not involve costs or fees, whereas fund managers do. As a result, the average fund manager must underperform the market, after costs.
So, is index investing the answer? There are contradicting opinions. On one hand, there is no doubt that index investing has its advantages. It has lower costs, is diversified, and is by definition more consistent. However, on the downside, there are disadvantages to using index funds, namely the fact that they are not flexible. Stock indices have considerable volatility, and during the next bear market or financial crisis, the index tracking funds will also, by definition, merely follow the stock indices down. In addition, as the number and complexity of exchange-traded funds and index funds grow, passive investors may end up with almost as many decisions to make as active investors face. It is thus important to buy the right exchange traded fund (ETF)!
In choosing a direction, investors need to weigh the pros and cons and decide on the trade-offs they are willing to make. Below is a summary of some of the benefits and trade-offs of active and passive investment.
As one can see, the arguments for and against each type of investment are fairly evenly balanced, and I would certainly not be surprised if an investor chose either strategy. Indeed, because we have respect for both sides of the argument, our own strategy might be said to be something of a hybrid between the two extremes.
**A hybrid approach**
I have outlined some bullet points that influence the Lorange family office and our investment activities in liquid asset classes:
* We stock-pick, but our portfolios are diversified enough to clearly have elements of market return.
* We are asset timers, but when selling our favorite stocks, we only sell 50%-75% of our position, as we may be wrong on calling a top in the stock or on the market.
* We are market timers, but when we “exit” a market, we rarely go fully out, as we might be wrong. For instance, we would never go completely out of the equity market, or even worse, be net short the equity market like some hedge funds. Why? Because the world’s population is growing and so are wealth levels. Global GDP is growing along with inflation, and central banks and politicians have a vested interest in maintaining well-functioning equity markets. Thus, in shorting the market, one has plenty of odds stacked against oneself.
* We keep costs reasonable. We do not invest in expensive hedge funds and asset managers who ask for “2 & 20%,” i.e., a 2% management fee and a 20% cut of the performance. Instead, we find managers who provide advice for below 1% per year, or brokers with commissions below 0.3% per transaction. We do not overtrade—on the contrary, holding each position longer both keeps the costs down and lets the investment ideas play out.
* We continue to learn and improve. When you are choosing advisors, wealth managers, and brokers, it is to be expected that not all of them will provide you with the advice needed to outperform the market. Given that fact, allocate more to the best sources of wealth management advice, scale back on the worst performers, and give new advisors a chance. Using such a Darwinian approach to investing will gradually increase the quality of the advice you receive. Furthermore, we as investors are often our own worst enemies. We must stay humble and avoid hubris. Indeed, we should have great respect for how difficult it is to manage money; wealth management takes great dedication, and is a skill—even an art—that must be continuously learned and developed. Lastly, if you are new to finance, start out carefully and take the time to learn.
* We maintain discipline. We do not lose much sleep if a single stock does not perform as expected, but one should generally use a disciplined approach to investing in order to counteract some of the psychological effects and cognitive biases that can wreak havoc on investment performance—the worst being the tendency for loss aversion, in other words, for not accepting necessary losses (i.e. not realizing the loss or using a rigorous “stop-loss”) and, similarly, taking profits too early. If one follows loss aversion to its logical conclusion, one’s portfolio will end up as a “Zwiebeln portfolio,” a portfolio of onions that will only make you cry.
* We acknowledge that asset allocation is more important than stock selection. Studies show that asset allocation is vastly more important than security selection or stock picking (one study found that 94% of the variation in total returns was explained by asset allocation, while only 6% was explained by stock selection). Financial newspapers often focus on individual stocks. However, as investors, we should be preoccupied by the direction and soundness of the overall market and of each asset class.
* We prefer to look at the risk-adjusted return. Of course, it sounds great to beat the market, and it sounds like a failure to underperform the market. But what if you have outperformed the market by taking vastly higher risks, or if you have underperformed the market by playing it safe and by holding cash at times as insurance against volatility? It seems obvious that the relevant measure of the portfolio’s performance must be the return seen in relation to the risk—the risk-adjusted return—and not the return irrespective of the risk taken to achieve the return (i.e., the absolute or gross return figure). Thus, when evaluating performance, you must assign the appropriate benchmark returns to the cash and stocks held on average throughout the year in order to see whether your portfolio has underperformed or outperformed relative to the risk-adjusted benchmark.
For example, if the market has gone up 10% and your portfolio has “only” gone up 7%, but if you have held, on average, 50% cash yielding zero and 50% stocks, then you have actually outperformed the market by 2%, relative to the risk you have taken (50%\*0 + 50%\*10= 5% vs. your 7% performance). Conversely, if the market has gone up 10%, while your portfolio has gone up 13% by using leverage, making very large cluster bets, or just holding a subsection of the market, such as small caps, you have outperformed, but at a higher risk than the market. Should the market turn downward, chances are that the same portfolio might underperform the market. Thus, the long-term risk-adjust return is again the relevant measure, not the gross number for a single year.
In the field of wealth management, the debate between active investing and index tracking is impossible (at least for one person) to resolve. This article can only point toward the arguments for and against each strategy, while outlining a middle-ground position that has worked fairly well for us. While it is perhaps more entertaining to take a more extreme position, we find investing to be full of grey areas, and dilemmas. There is no one solution that fits all. Rather, each investor must navigate her or his way through the dilemmas toward a solution that matches her or his needs, preferences, and aspirations. In the end, such educated personal judgment is perhaps the soundest investment decision.
**Discussion questions from the Lorange Network team**
1. What are the key arguments for active investing in stocks?
2. What are the key arguments for passive investing in stocks?
3. What are the key elements in a hybrid model?
4. How might one judge the cycle in the market?
5. How can family offices outperform stock market experts?
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