Advisors Should Go Beyond the 'Easy' Button
While indexing has benefits like lower costs, actively managed investments may offer advantages in some asset classes.
Advisors increasingly consider indexing the “easy” button of investing. Index-oriented approaches are low-cost, tax-efficient and simple to implement. Advisors who adopt index-oriented approaches may also have fewer difficult conversations with clients about underperforming managers.
The attraction of the “easy” button is understandable; however, advisors should consider the merits of integrating high-value-added active strategies with a core of low-cost, tax-efficient index strategies.
Index investments offer a compelling option in certain asset classes; actively managed investments may offer return or risk management advantages in other asset classes. Advisors seeking to combine passive and active investments should adopt an asset class-based framework.
Factors to consider include the probability, payoff and persistence of outperformance, as well as the quality of the index used for the asset class.
The major factors can be defined as follows:
- Probability of outperformance: The percentage of funds in the asset class that outperformed the index over a market cycle is a good starting point. For example, only a small percentage of U.S. large capitalization funds have outperformed relative to the S&P 500 Index over the past five years and numerous other rolling five-year periods. Although the failure of active managers to beat the index in the U.S. large-company universe gets the most press, active managers have demonstrated a higher probability of success in other segments of the market.
- Payoff from outperformance. Many advisors devote considerable effort to identifying the “best” manager in an asset class. The added investment cost and risk may not be worthwhile if “top performing” active managers in the asset class beat the index by a slim margin. The higher the return differential relative to the returns delivered by an index investment, the higher the potential payoff from active management.
- Persistence of outperformance: Top-performing funds often fail to sustain their success, in many cases reverting to the mean or in the worst-case scenario going from the top to the bottom quartile. In many cases, winning strategies employ an investment style or follow a theme that goes from being in favor to being out of favor. One way to assess the persistence of outperformance is to review what percentage of top quartile managers in one market cycle stay in the top quartile for the subsequent market cycle. The higher the percentage of “repeat winners,” the higher the likelihood that advisors will be able to select a manager able to sustain performance success.
- Quality of index: Some indexes are better than others at providing a transparent, liquid and inexpensive way to invest in an asset class. The Russell 1000 and S&P 500 indexes are good examples of indexes that meet those foundational requirements. Well-managed index funds can closely track the returns of either index. Not all indexes are as efficient as the Russell 1000 or S&P 500. Index performance in some asset classes may be influenced by the performance of less liquid index constituents, with hard-to-trade securities potentially making it more difficult for index funds to track index performance. Bond indexes may also present challenges, as in asset classes such as high yield, the biggest borrowers are the largest index constituents.
Using this asset-class-based framework as a guide, index investments are a compelling option for U.S. large-cap stocks. Most actively managed U.S. large-cap funds have trailed their benchmark index over multiple market cycles, and when they do “win,” the payoff is rarely worth the incremental cost and tax impact. Persistence of performance has also been low among U.S. large-cap funds.
The international small-capitalization equity asset class offers a very different story. As a significant percentage of managers beat the index, the payoff from beating the index is high, and there is relatively strong persistence of performance among the “winners.” Consequently, international small-cap equity is an asset class in which active management may be a better alternative than index investment.
In much of the fixed income market, active managers have outperformed their benchmark index, justified their fees and shown performance persistence. Active management may provide both performance and risk management advantages relative to index-oriented approaches within the fixed income universe. The largest constituents in fixed-income indexes are issuers (companies and countries) that borrow the most.
Active managers have the freedom to avoid riskier issuers or segments of the market, with active management being as much about avoiding the losers as about selecting the winners. The bond market has also been distorted in recent years by the increased importance of price-insensitive buyers such as central banks and sovereign wealth funds, creating more return enhancement opportunities for nimble investors.
Index and active investments used together offer potential benefits over strategies that invest exclusively in one or the other. Although adopting an index-oriented approach is undeniably easy, a systematic approach to combining index and active investments may yield better outcomes.