Investors have gravitated toward passive investments since the market crash in 2008, preferring their lower fees, liquidity and good performance over what many feel are too-risky actively managed investments. However, a white paper released in September by Osterweis Capital Management points out that while passive investments go up with the market, they also go down with it.
Indeed, the most important drawback to passive investments is that “they cannot provide protection to investors during down markets,” Osterweis wrote in the paper.
There are structural risks, too, though. The paper used the S&P 500 as an example. Because prices can decouple from earnings and cash flows, investors in products that track the S&P 500 may end up exposed to overvalued stocks or sectors, as we saw with the dot-com crash in the late ‘90s and the financial crisis in 2008, according to the paper.
A passive strategy doesn’t protect investors from companies with poor fundamentals, either, Osterweis wrote.
After five years of positive market returns, the benefits of active management are less clear. “It appears to be the popular opinion that active management and bottom-up stock picking do not generate sufficient outperformance over time to cover fees and transaction costs,” the paper said.
However, where active management proves its worth is in a down market. The “dispersion of returns in up and down markets provides active managers the opportunity to outperform,” the paper argued. Using the S&P 500 as an example again, Osterweis pointed out that in 2008, when the index fell 37%, some stocks within the index performed better. Some even had positive returns.
As if the overall drop in the index wasn’t bad enough, some stocks fell by 60% or more — Osterweis noted one stock fell 97%.
There are three ways active managers protect against downside risk, according to the paper. First is to maintain a truly active portfolio.
Osterweis warned against “closet indexers,” managers who build portfolios that look very similar to an index, even though they charge active management prices. Some managers may do so to stick close to a particular style box or to avoid clients’ negative reactions to short-term underperformance.
The firm recommended studying a fund’s active share: the percentage of a fund’s portfolio that differs from the benchmark. “A truly active portfolio manager is generally defined as having at least 60% active share,” the paper says.
The next strategy is to apply a risk-sensitive approach when selecting securities for the portfolio. Osterweis does this by selecting stocks with an “asymmetrical risk profile” — choosing stocks that are undervalued and avoiding those selling at a premium.
Just because a stock is cheap is no reason to invest, though. Osterweis focuses on companies with stocks that are inexpensive but recovering “from a problem that can be fixed” like a recently ousted portfolio manager or a bad acquisition.
“If we can identify stocks that we think are fundamentally sound and starting to recover, we believe it is likely that their prices should eventually reflect increased earnings and multiple expansion if the companies prove themselves and come back into favor,” the paper says.
Finally, an active manager should create a “high-conviction portfolio,” Osterweis wrote. “We invest only in those stocks where we have the highest conviction, and we are mindful of how constituents of our portfolio work together. This approach has enabled us to maintain a diversified portfolio that has historically dampened losses during significant down markets relative to the S&P 500.”
For a topical discussion of the active versus passive investing debate, sign up for a free ThinkAdvisor webinar on Oct. 15 featuring Tony Davidow of Schwab and Ben Warwick of Searching for Alpha (and get an hour of CFP CE).