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The
ACTIVE
VS. PASSIVE
Investing
Debate
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Executive Summary
Those in search of the best investment strategy want to
know if active or passive investing yields greater returns.
Though it is a commonly debated topic among investment
professionals and investors alike, the data show that passive
management yields better results over the long term.
Active managers underperform their
benchmarks:
• Of all actively managed U.S. funds, 81% of
equity funds and 92% of fixed-income funds failed
to outperform their benchmarks over the fifteen
years ending December 31, 2014.
• Of all of the equity mutual funds that existed
from 1965 to 1984, not a single fund generated
a statistically significant positive return compared
to its benchmark.
•Of the domestic equity funds that were in the
top quartile for performance as of March 2011,
only 0.28% managed to stay in that top quartile
after four years.
•After five years ending in 2014, nearly one
quarter of all domestic equity funds and global
and international equity funds could not even
manage to survive.
Past performance is not an indication of
future performance:
• Of the top 20 domestic equity mutual funds from
1996 to 2005, during the five subsequent years,
two ranked in the zero and second percentiles,
with the average ranking in the 66th percentile.
• Of all Canadian equity funds, only 45%
survived after five years, ending in 2009.
Positive returns are based on luck not skill:
• Each participant in the market has a 25%
chance of being in the top quartile and a
25% chance of being in the bottom
quartile.
• While a particular manager may have been in the
top quartile in the past, they have the same
chance as every other participant of being in the
top quartile in the future.
• If beating the market was due to skill and not
luck, more managers would be beating the
market.
Market predictions are ineffective:
• It is improbable that there is one person
who will systematically and consistently have
more information than the seven billion others to
correctly make market predictions.
• Missing the 25 best trading days since 1970
would leave an investor with 76% less than
if they had remained invested in the market.
Short-term investing can miss major gains:
• Since 1926, the bull markets in the S&P 500
Index have lasted nearly twice as long as bear
markets and have delivered price gains that are
disproportionately greater than the bear market
losses. Those gains have been nearly three times
greater than the losses.
• Reactions to short-term market movements can
compromise long-term performance. Despite
large average intra-year drops of 14.2%, annual
returns were positive in 27 of 35 years.
Active management is costly:
• Active managers typically have higher
management fees to cover the cost of research
and higher transaction costs because of the high
turnover of securities.
• The majority of the earnings from actively
managed mutual funds were made by the same
securities as those held by the passive benchmark
index. The remaining actively managed funds
earned limited returns while generating significant
costs.
• Actively managed domestic funds were more than
five times more expensive than passive mutual
funds, according to a study from 2012.
The evidence is clear that active management is a risky
investment option that often fails investors. Instead,
passive management involves no forecasting, stock
picking, or market timing. Passive managers seek to
capture the returns of the market either by using index
funds to represent an asset class or institutional assetclass funds to hold essentially all of the securities that
comprise an asset class. By developing an intelligent plan
with a long-range strategy and rebalancing the portfolio
to align with the original target allocation, passive
managers strive to keep the portfolio on track to pursue
long-term goals.
1
Which Yields Better Results — Active Or Passive Investing?
The investing public is consistently bombarded with
conflicting messages on how to best manage its money.
The media and many investment advisors constantly make
market predictions and name the hottest stocks. But is this
the best way? The debate remains: Does implementing an
active or a passive approach yield more lucrative
long-term returns?
Today, societal pressure calls us to act now, do not
just stand by, make things happen. These catch phrases
penetrate our everyday decision-making process, which
is precisely why it can be so hard for investors to resist
interacting with their money on a daily basis. We can feel
handicapped when we are not making changes and may
believe we are missing out on today’s hot stocks. However,
an investor who knows the advantages of a passively
engineered portfolio and can ignore societal pressures
is more likely to succeed over the long term.
Generally, active or tactical management is defined as the
art of selecting specific securities and attempting to time
the market. Active managers strive to recognize and invest
in companies they believe will post above-average returns.
They may look for companies with notable sales and
profits or innovative new products or one that is poised
to make a comeback after a time of poor performance.
All active managers, no matter what they look for in an
investment, purchase securities based on a forecast of
future events. Active management essentially relies on
predicting the future.
Passive management, however, involves constructing a
well-diversified portfolio that represents broad-based
financial markets without attempting to identify specific
securities that one hopes will be superior performers.
This approach can be applied to any asset class, including
large-cap, small-cap, value, growth, foreign, or domestic
stocks. Unlike active managers, passive managers do not
attempt to distinguish superior performing investments.
For instance, a passive manager would not decide if Apple
is preferable to Microsoft but instead would construct
a portfolio that represents a variety of asset classes,
using either index funds to represent an asset class or
institutional asset-class funds to acquire essentially all of
the securities that comprise an asset class. In either case,
the resulting passively constructed portfolio would hold
hundreds or even thousands of stocks. Furthermore, a
passive manager who uses institutional asset-class funds
would actually construct a portfolio that holds nearly
every publicly traded company. Whether index or assetclass funds are used, the goal is to create a portfolio that
closely resembles the performance and, in turn, captures
the returns of the global markets. Well-recognized market
benchmarks are used to compare returns for each
particular asset class, such as the Standard & Poor’s 500
Composite Index for large U.S. companies or the Morgan
Stanley EAFE Index for large foreign companies.
2
Playing The Game Of Active Management — The Evidence
Many successful wealth managers and market experts
agree that using an active management strategy is a lot
like a game of Monopoly, winning and losing money each
time you play. At the end of the game, you put the surviving
pieces of your investment portfolio back in the box, having
risked too much, wishing for a different outcome. Here, we
will explore the evidence that defends those who prefer
investors do anything with their money but play games.
Active Managers Underperform Their Benchmarks
There is a plethora of data that show active management
underperforming the market over the long term. Active
managers’ attempts to time the market often leave
investors disappointed. Their claims are riddled with
marketing spin and often only show good returns
over a relatively short period of time.
When active managers are put to the test, the data show
that most active managers typically fail to add value.
And over longer periods of time, they are more likely to
underperform their respective benchmark. Figures 1 and 2
offers recent evidence of this, showing the percentage of
U.S. equity and fixed-income funds that survived and were
able to outperform their benchmark after periods of three,
five, ten, and fifteen years, ending December 31, 2014.
The size and complexity of the mutual-fund landscape
masks the fact that many funds disappear each year, often
as a result of poor investment performance. After three
Figure 1: Percent of U.S. Equity Funds That
Survived and Outperformed Their Benchmarks
after 3, 5, 10, and 15 Years, as of Dec. 31, 2014
Data provided by Dimensional Fund Advisors
years, 85% of equity funds and 88% of fixed-income funds
survived. Over time, fund survival rates dropped sharply.
After fifteen years, only 42% of equity funds and 41% of
fixed-income funds managed to survive.
Investors likely have a more ambitious goal than to
just pick a fund that survives. Most people are on a
hunt for funds that will provide superior performance.
Unfortunately for many investors, after three years, 69% of
equity and fixed-income funds failed to outperform their
benchmarks. Fund performance results are even worse
over longer horizons. After fifteen years, 81% of equity
funds and 92% of fixed-income funds failed to outperform
their benchmarks. Over both short and long time horizons
and for both equities and bonds, the deck is stacked against
the investor seeking outperformance.
One of the most comprehensive studies of actively
managed funds was conducted by Elton, Gruber, Hlavka,
and Das. In this study, they examined all equity mutual
funds that existed from 1965 to 1984. These funds were
compared to the set of index funds that most closely
reflected the actual funds’ investment choices, including
large stocks, small stocks, and fixed income. Over the
20-year period, the equity funds underperformed the
index funds by 159 basis points on average each year.
Furthermore, not a single fund generated a statistically
significant positive earning.
Figure 2: Percent of Fixed-Income Funds That
Survived and Outperformed Their Benchmarks
after 3, 5, 10, and 15 Years, as of Dec. 31, 2014
Data provided by Dimensional Fund Advisors
3
In another study, Mark Carhart reviewed the performance
of 1,892 funds that existed from 1961 to 1993. His
extensive analysis showed that the actively managed funds
underperformed their benchmark by an average
of 1.8% per year.
Looking at more recent data, Standard & Poor’s publishes
a quarterly analysis called Standard & Poor’s Index Versus
Active that shows the performance of active funds versus
their benchmarks. The analysis consistently suggests
that while active managers may achieve short periods
of outperformance, over longer periods of three to five
years, they rarely outperform their benchmarks. Whether
Standard & Poor’s analyzed funds in broad categories,
such as all large-cap U.S. stock funds, or looked at smaller
segments, such as New York municipal-bond funds, it found
that the vast majority of funds consistently lagged behind
their asset-class’s benchmark index, the very index they
were attempting to beat.
Furthermore, Figures 3 and 4 show the failure of actively
managed equity and fixed-income funds over the last
five years, as of June 30, 2015. During this time, the vast
majority of funds failed to outperform their respective
market benchmark. In most equity asset classes, more than
70% of active managers failed, as seen in Figure 3.
Additionally, Figure 4 presents the number of fixed-income
funds that failed during the same five years. Seven out of
ten fixed-income funds failed to beat their benchmark over
the last five years in the majority of fixed-income asset
classes.
Figure 3: Percentage of Equity Funds That Failed to Beat the Index During Prior Five Years, as
of June 30, 2015
Data provided by S&P Dow Jones Indices, LLC
Figure 4: Percentage of Fixed-Income Funds That Failed to Beat the Index During Prior Five
Years, as of June 30, 2015
Data provided by S&P Dow Jones Indices, LLC
4
Additionally, The Wall Street Journal asked Morningstar to
evaluate the performance of active managers during the
economic slowdown of 2008. During this time, active
funds fell behind their benchmarks in six of the nine
major categories. Morningstar also discovered that active
managers performed worse during this recession than
in previous recessions. While many active managers claim
they have the knowledge and foresight to time the market
to curb losses for their clients, this study suggests that
active managers often fail to avoid a market downturn.
Relying on their claims and assurances can lead to
false hopes.
Over and over again, these facts and figures show that
active investment managers are failing to beat the market
and are being outperformed by the benchmarks they are
striving to beat. While there are sporadic periods of aboveaverage results, 50 years of historical data convey that the
efforts of active managers to beat the market result in
underperformance, and the only consistent performer in
any asset class is the market itself. While active managers
continually assert that they can outperform, in reality, they
are not beating the market, but, rather, the market is beating
them. Instead of attempting to beat the market
and most likely failing, investors should strive to capture the
returns of the market by employing a passively engineered
strategy.
Past Performance Is Not an Indication of
Future Performance
Furthermore, a recent Standard & Poor’s Index Versus
Active U.S. Scorecard looked at the performance of equity
funds over the five-year period ending in 2014. During
this time, 24% of both domestic equity funds and global
and international equity funds did not survive. If nearly a
quarter of equity funds did not survive these five years,
how many are likely to survive 10, 20 or even 50 years?
Many investment managers boast of their past results
in an effort to gain future clients, showing great returns
from a previous time period. While a manager may have
performed well in the past, it is unlikely that he or she will
continue to earn those great returns in the future. History
shows that past performance is not an indication of future
performance, and this year’s winners may be next year’s
biggest losers. Figure 5 shows the performance of the
top 25% of domestic equity funds over five consecutive
twelve-month periods. Out of the 703 domestic equity
funds that were in the top quartile for performance as
of March 2011, only 4.69% managed to stay in that top
quartile after two years. And after four years, only 0.28%
were still in the top quartile. It is important to note that
none of the large-, mid-, or small-cap funds managed to
stay in the top quartile after four years. While managers
may flaunt their past performance, it is no indication of
future performance, and history shows their futures will
not likely be nearly as bright.
Often times, when managers boast of their performance,
they remove those dead funds from calculations, skewing
the results in their favor. Brad Steiman, director and head
of Canadian Financial Advisor Services, said that making
claims based on only the small sample of surviving funds
“would be like attending a World War II fighter pilot
convention and concluding that being a World War II
fighter pilot results in longevity because everyone at the
convention was over 80 years old.” Those funds that did
not survive must also be accounted for, just like the fighter
pilots. Data are often twisted in the manager’s favor, and
the whole picture is rarely presented. Legendary investor
Bernard Baruch said, “Only liars manage to always be out
during bad times and in during good times.”
Figure 5: Performance Persistence of Domestic Equity Funds Over Five Consecutive
Twelve-Month Periods
Mutual Fund Category
Fund Count
at Start
(March 2011)
March 2012
March 2013
March 2014
March 2015
All Domestic Funds
703
30.87
4.69
1
0.28
Large-Cap Funds
269
30.86
3.72
0
0
Mid-Cap Funds
101
28.71
0
0
0
Small-Cap Funds
148
30.41
6.08
1.35
0
Multi-Cap Funds
185
32.43
7.57
2.7
1.08
Percentage Remaining in Top Quartile
Data provided by S&P Dow Jones Indices, LLC
5
Positive Returns Are Based on
Luck Not Skill
While there is a plethora of investment research, there
is not one major published study that effectively proves
that managers beat the markets more than one would
expect by chance. For the millions of participants in the
market, each has a 25% chance of being in the top quartile,
as well as a 25% chance of being in the bottom quartile.
While a particular manager may have been in the top
quartile in the past, that manager has the same chance as
every other participant of being in the top quartile in the
future, regardless of his or her past performance. Future
performance is independent of prior experience.
If beating the market was due to skill and not luck, more
managers would be outperforming the market. But the
data show that the number of managers beating the
market is equal to the number who would do so purely by
chance. Because past winners may have just been lucky, it
is nearly impossible to pinpoint a manager who will beat
the market in the future. William Bernstein wrote in The
Intelligent Asset Allocator, “There are two kinds of investors,
be they large or small: Those who don’t know where the
{
market is headed, and those who don’t know that they
don’t know. Then again, there is a third type of investor—
the investment professional, who indeed knows that he
or she doesn’t know, but whose livelihood depends upon
appearing to know.” In the end, you only have one option:
to invest with an investment professional who does not
know where the market is headed. So pick a manager
who does not pretend to know where it is going. Passive
managers admit they do not know what the market
will do and, therefore, avoid market predictions. Instead,
their strategy is engineered to capture the returns of the
market, not gamble on investments they hope will do well.
“There are two kinds of investors, be they large or
small: Those who don’t know where the market is
headed, and those who don’t know that they don’t
know. Then again, there is a third type of investor—
the investment professional, who indeed knows
that he or she doesn’t know, but whose livelihood
depends upon appearing to know.”
}
-William Bernstein,The Intelligent Asset Allocator
6
Market Predictions Are Ineffective
The basis of active management is investing in companies
that are predicted to post above-average returns. Much
of what active managers do is attempt to gain insight into
the future performance of a company. They may look for
a company posting significant sales and profits or one that
is touting the launch of a new product. However, while a
manager is gathering this information, there are thousands
of other individuals, analysts, and investment advisors who
are also collecting this information. The information they
are basing their predictions on is already reflected in the
price of the stock because all of the other investors have
this information too and are investing with it in mind.
For example, if Apple announces that it will be launching
the next great device, which will completely alter
electronic communication, the price of the stock will
quickly increase because there are many investors buying
it, hoping that the stock price will continue to rise when
the product is launched. The market instantly digests the
information and reflects it in stock prices. Therefore,
there is no advantage to endlessly seeking information
on individual companies as it is unlikely that there is one
person who will systematically and consistently have more
information than seven billion others.
Market timing, the foundation of active management, may
seem to offer a seductive prospect, with an active manager
boasting of his or her ability to use market predictions to
capture only the best-performing days and avoid the worst.
But Figure 6 tells the other side of that story. Large gains
often come in quick, unpredictable surges. A manager who
incorrectly predicts events may leave the market at the
wrong time, pulling out before a large surge. By missing
only a small fraction of days, especially the best days, a
market timer’s portfolio can be destroyed.
For example, since 1970, if an investor missed any of the
best trading days, his or her annualized compound returns
would be significantly less than those of the S&P 500 Index.
If an active manager incorrectly predicted and missed
those 25 best days, he or she would have 76% less than if
the active manager had stayed in. Attempting to forecast
which days or weeks will yield good or bad returns is a
guessing game that usually proves costly for investors.
Figure 6: Performance of the S&P 500 When Its Best Days Have Been Missed, From January
1970 Through August 2014
Data provided by S&P Dow Jones Indices, LLC
7
Short-Term Investing Can Miss Major Gains
Active managers often try to time the market to get
out before a bear market, a time of decline, strikes. A
bear market is identified in hindsight when the market
experiences a negative daily return followed by a
cumulative loss of at least 20%. The bear market ends at
its low point, the day of the greatest negative cumulative
return, before the reversal.
Since 1926, the bull markets in the S&P 500 Index
have lasted nearly twice as long as bear markets and,
more importantly, have delivered price gains that are
disproportionately greater than the bear-market losses.
Those gains have been nearly three times greater than
the losses. For those passive managers who stayed in the
market the whole time, the losses of the bear markets
were negated by the much greater gains. However, when
an active manager attempts to time the market and gets
out at the wrong time, which happens often, it can be
devastating to the manager’s portfolio because he or she
may miss the monumental gains. When an investor stays in
the market over the long term, he or she is able to endure
the downturns because the upturns have historically offset
them. Moreover, the passive manager reaps all of the gains
of the bull markets, which active managers may be missing.
Secondly, bull markets may have short-term dips, and the
bear markets may have short-term advances. Figure 7
illustrates the lowest point of the stock market during
each calendar year, as shown by the dot, compared to
the market’s return for the full year, as shown by the bar.
History shows that though the market dips each year,
it is clear that the market is capable of recovering from
intra-year drops and finishing the year in positive territory.
However, it is nearly impossible to determine when the
market is in a sustained downturn, hence the difficulty of
accurately predicting and timing market cycles.
As seen in Figure 7, despite average intra-year drops of
14.2%, annual returns were positive in 27 of 35 years. Thus,
it is crucial to maintain a disciplined investment approach
that views market events and trends from a long-term
perspective. Investors who react to short-term market
movements risk making poorly timed decisions that
compromise long-term performance.
Figure 7: S&P 500 Intra-Year Declines versus Calendar-Year Returns,
from 1980 through July 2015
40%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
-60%
1980
1985
1990
1995
2000
2005
2010
2015
Data provided by J.P. Morgan Asset Management
8
Active Management Is Costly
Active managers regularly buy and sell securities in their
clients’ portfolios, attempting to select the investments
they believe will perform best. With each buy or sell
transaction, there is a cost. Comparisons of the cost
of active and passive management indicate that active
management is the most expensive investment approach.
Active managers typically have higher management fees
to cover the cost of research and higher transaction
costs because of the high turnover of securities from
attempting to beat the market. As well, active investment
management’s higher security turnover can also increase
an investor’s tax burden if the investment turnover results
in short-term capital gains, instead of long-term capital
gains, which are taxed at lower rates.
Additionally, Figures 8 and 9 display the expense ratio
for domestic and international mutual funds. This study
was conducted using mutual fund expense ratios as of
August 21, 2012 and asset weighting based on net assets
as of July 31, 2012. The average expense ratios for active
funds were more than 50% greater than passive funds.
When the weighted average was calculated, the actively
managed domestic funds were more than five times more
expensive than the passive funds, and the actively managed
international funds were more than three times more
expensive than the passive funds.
Figure 8: Domestic Mutual Fund Expense
Ratios
The cost of an actively managed portfolio varies greatly
and is often masked to clients. Because the total cost is a
combination of management fees, transaction fees, the cost
of cash, the market impact cost, and taxes, clients of active
investment managers often do not know how much they
are truly paying.
In fact, most actively managed mutual funds actually hold
many of the same securities as those held by their passive
benchmark. It is those securities that have been found
to earn the majority of the mutual funds’ return. But
that is only half the story. Measuring the True Cost of Active
Management by Mutual Funds by Ross M. Miller goes on
to show that the majority of the costs of mutual funds is
generated by the securities that are actively managed and
are not commonly held by the benchmark index. Miller
found that, at the end of 2004, the average expense ratio
for the actively managed portion of actively managed
large-cap equity mutual funds tracked by Morningstar was
7%, more than six times their published expense ratio of
1.15%. This means that 7% of any gains obtained through
active management would automatically be offset to cover
expenses. In other words, any enhanced portfolio returns
earned as a result of active management must overcome a
7% hurdle before any actual investment gains are realized.
So the bulk of the earnings were made by the same
securities as those held by the passive benchmark index,
and the remaining actively managed funds generated the
high costs.
Figure 9: International Mutual Fund
Expense Ratios
Data provided by Morningstar
9
{
“After costs, the return on the average actively
managed dollar will be less than the return on the
average passively managed dollar for any time
period.”
- William F. Sharpe, 1990 Nobel Laureate
More cost does not equal greater returns, however.
Research shows that managers who charge extraordinarily
high fees and have extremely high turnover are more likely
to persistently underperform the market, net of fees and
expenses. Are those odds you would like to play?
On the other hand, passive managers recognize and
avoid the excessive cost and poor performance of active
investment management. Knowing the impact of trading
costs on returns and the low probability for success with
stock picking and market timing, passive managers offer
a less costly alternative. Primarily because of their lowcost structure, passively managed investments typically
outperform actively managed funds over the long term.
}
Active Management Is a Losing Game
Active management, while it may sound alluring, is riddled
with flaws. As the data show, active managers consistently
fail to outperform the very benchmark they are attempting
to beat because it is very difficult to regularly predict the
market correctly. Active management is also expensive, at
times costing clients more than five times what a passively
managed fund would. Identifying a manager who will
perform well in the future is nearly impossible because
past performance does not dictate future performance,
and beating the market appears to be based on luck more
than skill. The data strongly suggest that active management
fails to deliver its promise of superior
returns time and again.
As a columnist for The Wall Street Journal, Jonathan
Clements penned this warning, “Ignore market timers,
Wall Street strategists, technical analysts, and bozo
journalists who make market predictions ... Admit to
your therapist that you can’t beat the market. Investors
would also benefit by remembering this simple phrase:
Trading is hazardous to your wealth.”
10
Playing It Safe With Passive Management — The Evidence
Fortunately for investors, active management is not the
only option. Instead of playing the game, the passive
investor decides it is better to avoid the game and the
endless options. Many successful wealth management firms,
investment writers, and, of course, the wealthy employ
a passively engineered investment strategy. Let’s look at
what makes passive management the prudent choice when
selecting a long-term investment strategy.
Passive Management Is Not Inactive
While passive management may sound sedentary, it is
only passive with respect to actions that research
suggests do not add value, such as market timing. In
reality, passive management is actually quite active and
does so to the benefit of its clients. Passive managers
systematically construct portfolios to balance risk and
returns while executing these strategies patiently and
efficiently. This disciplined asset-class approach inherently
involves no forecasting, stock picking, or market timing.
Passively engineered investment management is based on
prudent guidelines, and its benefits can be reaped by those
who choose to work with a passive investment manager
who implements it.
The foundations of passively engineered investment
management are asset-class investing and remaining
invested through the inevitable ups and downs of market
cycles. Asset-class investing can be accomplished by using
index funds to represent an asset class or by selecting
institutional asset-class funds, which invest in virtually every
security that comprises an asset class. Using historical
data, passive managers can form reasonable estimates
of the overall volatility for a given asset class and can
approximate how closely its performance correlates
with the performance of other asset classes. Through
combinations of asset classes, asset allocations are created.
Each allocation has unique estimated risk and expected
return characteristics. Each client can find an overall
allocation that best matches his or her risk and return
tolerances. Finally, the asset allocation can be implemented
precisely by investing in those asset classes. The resulting
portfolio is easy to explain and understand, verifiable, and
highly defendable.
Passive Management Is Not a Buy-and-Hold
Approach
It is a common misconception that passive management
is a buy-and-hold strategy, which believes that in the long
term, markets produce a good rate of return despite
periods of volatility or decline. While passive managers
do believe in the futility of attempting to outperform the
markets, systematic rebalancing of portfolios without
market predictions is crucial to proper implementation of
the passive approach.
Over time, some assets will appreciate in value while
others decline. This causes a portfolio’s allocation to skew,
changing the level of risk and return. Eventually, it will
drift far enough away from the original allocation that the
original objectives are no longer being met. Because the
original portfolio was aligned with the investment goals
and risk tolerance, its integrity should be preserved. The
solution is rebalancing, reducing assets that have risen in
value and purchasing assets that have dropped in value.
While selling assets that are performing well and buying
those that are underperforming may be counterintuitive,
one must remember that positive past performance may
not continue, and there is no reliable way to predict
future returns.
Through rebalancing, the portfolio will return to its
original target allocation, putting the portfolio back on
track to pursue long-term goals. It is prudent to return to
the original asset allocation, as it reflects the desired risk
and return preferences. It also enables an investor to buy
low and sell high without making any market predictions.
By using structure, not recent performance, to make
investment decisions, rebalancing realigns the portfolio
to these priorities. Furthermore, a properly structured
portfolio provides a basis for making adjustments when
one’s overall financial situation or goals change. Without a
quantifiable plan, adjustments are a guessing game.
11
Figure 10: Annualized Long-Term Returns of
Equities and Active Managers, Since 1984
S&P 500 Outperforms Active Managers
The Quantitative Analysis of Investor Behavior compiles
yearly data comparing the performance of the S&P 500
to that of the average investor, who typically employs an
active investment strategy. The S&P 500 column in Figure
10 represents a passively managed portfolio. Over the last
thirteen years, the average investor has underperformed
the S&P 500 by an average of more than 7.5%. While
investors often base investment decisions on their market
predictions and gut feelings, they do this under the guise
of sound judgment and analytical reasoning. But in the end,
they fail to outperform a passive investment strategy, as
seen in Figure 11.
Year
S&P 500
Average
Equity Fund
Investor
Difference
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
17.90%
18.01%
16.29%
14.51%
12.22%
12.98%
13.20%
11.90%
11.80%
11.81%
8.35%
8.20%
9.14%
7.81%
8.21%
4.22%
9.85%
7.25%
7.23%
5.32%
4.17%
2.57%
3.51%
3.75%
3.90%
4.30%
4.48%
1.87%
3.17%
3.83%
3.49%
4.25%
5.02%
5.19%
-10.65%
-10.78%
-10.97%
-10.34%
-9.65%
-9.47%
-9.50%
-8%
-7.50%
-7.33%
-6.48%
-5.03%
-5.31%
-4.32%
-3.96%
-4.20%
4.66%
Data provided by Dalbar, Inc.
Figure 11: S&P 500 Versus Average Equity Fund Investor Returns
20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
1998
1999
2000 2001 2002 2003 2004 2005 2006 2007 2008
S&P 500
2009 2010 2011 2012 2013 2014
Average Equity Fund Investor
Data provided by Dalbar, Inc.
12
Concentrated Portfolios Are Hazardous
Some active managers encourage concentrating a portfolio
to hold a small number of different securities that they
believe will fare well. For example, a concentrated portfolio
might be one that holds a limited number of stocks,
one where an individual stock comprises a meaningful
percentage of the total portfolio, one that invests heavily
in only a few economic regions, or one that has most of its
holdings in one or a few asset classes. Regardless of which
type of concentration is used, a concentrated portfolio can
be hazardous to an investor’s wealth.
A concentrated portfolio is like a giant redwood tree
towering high above a forest of saplings. When a storm
rolls in, which tree is most likely to be struck by lightning?
As portfolios become more and more concentrated in a
small number of investments, asset classes, or economic
regions, they increase their risk of devastation if they
are struck.
But not only are storms inevitable, they are frequent. Many
investors are shocked by the frequency at which lightning
strikes occur. A study was conducted in 2011 regarding
the percentage of individual companies in the S&P 1500
that underperformed the market. Over the thirteen years
in the study, 39% of the 1500 companies underperformed
the index by more than 15%, as shown in Figure 12. That
is nearly a two-in-five chance that an individual investment
gets struck. When the strike occurs on an investment that
makes up a significant portion of your portfolio, the results
can be catastrophic. Not only can a strike occur on an
individual investment, it can also occur on an asset class or
on an economic region.
While lightning strikes are also likely to occur in a passive
broadly diversified portfolio, this type of portfolio is
constructed to withstand the hit. Diversification can help
eliminate unsystematic risk in a portfolio. In essence, with
a diversified portfolio, you are likely to lose only a few
small saplings, not the giant redwood, when lightning
strikes. Broad diversification can provide investors peace
of mind when weathering a financial storm and can help
them overcome the impulse to run for shelter at exactly
the wrong time.
Figure 12: Percentage of S&P 1500
Companies Underperforming
by 15% or More
Time Period
Percentage
2010
18%
2009
31%
2008
30%
2007
58%
2006
34%
2005
42%
2004
33%
2003
34%
2002
31%
2001
32%
2000
45%
1999
45%
1998
71%
Average
39%
Data provided by Dimensional Fund Advisors
13
Passive Management Outperforms Active Management
Investors are presented with a fundamental choice
when choosing with whom and how to invest their life
savings. But research suggests that passive management
yields better returns, as passive managers consistently
outperform active managers over the long term. Passive
managers construct portfolios that capture the returns of
the market, while active managers attempt to predict the
future using market timing to beat the market. But in the
end, most active managers fail, with more than 80% of all
actively managed funds failing to outperform the market
over a fifteen-year period. And over the last thirteen years,
active investors have underperformed their benchmark
by an average of more than 7.5%. Not only are active
managers failing, they are failing greatly. Moreover, because
future performance is independent of past performance,
it is nearly impossible to identify in advance a manager
who is likely to perform well. Though active managers may
boast, their chances at succeeding over the long term are
small.
The foundation of active management, market timing, is
overcome with drawbacks. Market timing often proves
ineffective as active managers can miss the best trading
days when they incorrectly predict where the market is
headed. If a manager missed only 25 of the market’s best
days, the manager’s returns would have decreased by
75%.Yet, missing even only one day can be hazardous to
a portfolio’s return. Instead, passive managers choose to
remain invested through market cycles to reap the gains
of the best days to effectively weather the downturns.
Market timing and active management also cost their
clients more. From increased management fees to cover
endless research to mounting transaction costs for trading
securities, actively managed domestic funds are more than
five times more expensive than passive funds.
Passive management fundamentally involves no forecasting,
stock picking, or market timing. Instead, passive managers
seek to capture the returns of the market. This can be
accomplished either by using index funds to represent
an asset class or institutional asset-class funds to hold
essentially all of the securities that comprise an asset class.
By investing in a combination of asset classes, a passive
manager can estimate the risk and expected return of the
total portfolio and can find an overall allocation that best
matches the preferences of the client. Passive managers
use structure, not recent performance, to make investment
decisions. By developing an intelligent plan with a longrange strategy and rebalancing the portfolio to align with
the original target allocation, passive managers strive to
keep the portfolio on track to pursue long-term goals.
Jentner Wealth Management is a nationally
recognized wealth-management firm based
in Akron, Ohio. By providing fee-only
comprehensive financial planning, globally
diversified investing, and fiduciary advice,
Jentner seeks to preserve the financial
legacy of clients in Northeast Ohio and
across the United States. Founded in 1984,
Jentner Wealth Management provides
both financial planning and investment
management to individuals, families
and trusts. Jentner Global Management
is a specialized division that provides
institutions with investment portfolio
management services, including portfolios
customized specifically for endowments
and foundations. Jentner’s proven, lowcost passively-engineered investment
strategy invests broadly in more than
14,000 companies on six continents, seeking
to provide steadiness in good times and
challenging times to earn meaningful
returns over the long term. For more
information, please visit www.jentner.com
or call 1-866-JENTNER.
© 2015 Jentner Wealth Management
14