Indexing vs. Active Management: The Adviser Investments Perspective

Active or passive? The debate rages on: Is it better to put your investment dollars in the hands of a professional (and pay for their expertise) or to cut costs and try to match the return of the market with an index fund?

As recently as 2019, pundits were ready to anoint passive the winner after news that index funds’ collective assets under management had surged passed those in actively managed funds. But when the COVID-19 pandemic brought extreme volatility to the markets in 2020, those same headline writers now declared it active investing’s moment in the sun.

At Adviser Investments, we believe that the key to successful investing is to be an informed investor—that means looking beyond the headlines to understand the merits of both active and passive investing, and the role each can play in your portfolio. This special report explains the pros and cons of both investment styles, as well as where we stand in the great debate and how we incorporate our philosophy into the management of more than $5 billion for individuals and organizations.

Experts, Indexes, Benchmarks and Markets

So, what do we mean when we talk about “active” and “passive” funds?

An active fund is one overseen by a professional fund manager. When it comes to their health, their home or their car, most people want an expert to take care of them. Active fund managers fill this role in a portfolio, applying a career’s-worth of experience to pick baskets of stocks and bonds with desirable characteristics for their shareholders. Their goal is typically to beat “the market” or another benchmark over time through faster growth or by providing better defense during bear markets and pullbacks.

Passive funds don’t try to select the best investments in a given sector or style. Instead, these funds invest a proportion of their funds into every security tracked by their benchmark, typically a broad-based market index or a narrower market sector or asset class index. As their benchmark index rises or falls, so does the value of the passive fund.

Because fund shareholders aren’t paying a professional stock- or bond-picker for their expertise, passive funds generally charge substantially lower fees than their active counterparts. Unlike active funds, passive funds never aim to beat their fund’s benchmark, merely match it—but that can be enough to surpass the return of an active manager over time, especially once fees are taken into account.

Any discussion of the merits of active verses passive investing must also include an explanation of what exactly an index is. Because when the media talks about “the stock market,” it’s almost always referring to stock market indexes, and they’re not quite the same thing.

There are thousands of companies whose stock is publicly traded in the U.S. (about 4,400 as of 2018). The price of a single company’s stock reflects investors’ assessments of its prospects, which may or may not match the outlook for the broader economy. (For example, videoconferencing technology provider Zoom saw its stock soar even as the overall economy fell into recession during the pandemic.)

Collectively, however, stock prices may offer some insight. In the late 19th century, Charles Dow, founder of The Wall Street Journal, first proposed that by tracking the ups and downs of the stock prices of the country’s biggest and most influential companies and averaging them together, you could create a barometer of the state of the overall economy. Together with statistician Edward Jones, he created the first stock market index to do precisely that. The Dow Jones Industrial Average (DJIA), which launched in 1896, is still widely followed today.

The DJIA, however, tracks the prices of only 30 stocks—a very small slice of the total market. Another popular index, the Standard & Poor’s 500 stock index (S&P 500), is more inclusive, comprising 500 stocks issued by large U.S. companies. Both aim to turn the chaotic dips and rises of trading thousands of stocks into a single daily number that gives insight into how “the market” is doing—shorthand that’s made them popular with journalists and investors ever since.

The firms that sponsor these indexes are in charge of deciding what securities to include in their snapshot of the market. Employees of The Wall Street Journal determine the composition of the DJIA. A selection committee at Standard & Poor’s oversees the S&P 500 and the firm’s other indexes. For most index-makers, the goal is minimal turnover—that is, changes in the underlying securities. But indexes are not set in stone. For example, in 2019, there were 20 changes (each addition is coupled with a deletion) to the S&P 500.

Though the S&P 500 and the DJIA may be the most commonly cited indexes in the press, they’re far from alone. There are hundreds of indexes out there, covering different sectors, regions and investment styles. Each is comprised of a slightly different selection of stocks; none cover all publicly traded stocks (though the Russell 3000 comes close).

Every index provides a window on the market, but none offers a panoramic view. And that’s important to know, because indexes play an important part in both active and passive investing. Passive investing is simply choosing a mutual fund or ETF that tracks an index. The composition of and rules for inclusion in that index determine performance—and whether your investment will perform as you hope. Currently, there are nearly 500 mutual funds and more than 1,700 ETFs in the business of tracking an index.

For active investment managers, indexes act as the benchmarks against which their performance is measured. Through careful research, these managers attempt to look for attractively priced stocks within and beyond the relevant index for the sector or style they invest in—and by doing so, seek to provide shareholders with better returns than investing in an index-tracking fund would.

The Nuts and Bolts of Active vs. Passive

Anyone making a case for active management must first start by acknowledging the elephant in the room: The majority of active managers don’t beat their benchmark. A recent study by Standard & Poor’s found that, looking back over 10 years, as many as 89% of actively managed U.S. equity mutual funds failed to outperform their benchmark index over the course of the record-long bull market that ran from 2009 to early 2020.

But while it’s true that the majority of active managers fail to beat their benchmark index over time, it’s also true that some can and do. If you can identify the successful minority of fund managers who produce those index-beating returns, your portfolio is going to outperform a passive investment approach. (And at Adviser Investments, we have a research and investment team dedicated to this pursuit; we discuss how they do so below.)

Manager underperformance can also vary massively depending on the style of fund you’re investing in. That same S&P study found that while 71% of large-cap mutual funds failed to post a return that was better than the S&P 500 in 2019, mid-cap managers did much better. The benchmark mid-cap index only beat 32% of portfolio managers. Small-cap fund managers also did comparatively well. In 2019, only 39% of managers who focused on small-cap stocks failed to beat a benchmark.

The large-cap active managers’ struggles with beating their benchmarks helps explain why the bulk of money invested in index mutual funds and ETFs is concentrated in portfolios that focus on large-cap stocks. For example, ETFs devoted solely to U.S. large-cap stocks represent almost one-third of total ETF assets, while ETFs focused on mid- and small-cap stocks account for a total of 10% of ETF assets.

Many investors use passive funds to add a degree of broad diversification to their portfolios, feeling that investing in a passive fund tracking the S&P 500 gives you a stake in the overall market on the cheap. But this can be a bit misleading. In fact, because many indexes are market-weighted, the bulk of assets end up concentrated in a small number of stocks. For example, the 10 largest holdings in the S&P 500 account for nearly 20% of the assets in an S&P-tracking fund, and the 50 largest of the 500 stocks in the index account for over 50% of assets.

Index and ETF Fee Advantage

One of the main reasons the majority of mutual fund managers fail to keep pace with their benchmark index is cost. The annual fees charged by an active fund tend to be much higher than for an index fund or ETF. This annual fee, called an expense ratio, is levied to cover operating and administrative costs. The average expense ratio for an actively managed large-cap stock mutual fund is about 1%.

But the average for a large-cap index fund is about 0.35%, and in August 2018, Fidelity debuted a suite of zero-fee index funds. ETF expense ratios can be even lower than those for a similar index mutual fund (though we have yet to see any go less than zero).

All those numbers may seem small, but one of the most important keys to successful investing is to appreciate that every penny you are able to keep in your portfolio rather than paying ongoing fund expenses is another penny that can compound over time and help you meet your long-term goals. Take a look at the impact expenses have on the long-term growth of a $10,000 investment in the table below.

That’s a clear picture of how crucial expenses are. Two funds with identical gross returns have vastly different net (after expense) returns; in our example, the lower-cost Fund B leaves an investor with nearly $7,700 more over the 20-year period.

A Human Being Can Manage Risk

As the saying goes, a rising tide lifts all boats. During the 2009–2020 bull market, it was especially difficult for active managers to find an edge. But things aren’t always so calm, and in stormy markets, active managers have more tools to help manage risk. An adept manager can reduce the fund’s losses by using a variety of techniques: Scaling back the most volatile stocks in the portfolio or perhaps increasing the portion of fund assets invested in cash. Consider that in 2002, when its benchmark, the S&P 500, lost more than 22%, Fidelity Contrafund fell less than 10%.

In contrast, when stocks or bonds hit a rough patch, an index fund or ETF is going to ride that market drop in lock-step with its benchmark index.

The Tax Factor

Indexing has some advantages when it comes to keeping your investing tax bill low. When fund managers sell a portfolio holding for a profit, the law requires that they pass the “realized capital gain” along to shareholders each year. This has nothing to do with any trading you might do during the year; even the most devout buy-and-hold fund investor who doesn’t touch her portfolio can be hit with a tax bill at the end of the year if a fund had any realized capital gains.

Indexing can reduce the chance of any tax bill while you remain invested, given that there is no “active” buying and selling of securities. An index mutual fund doesn’t completely eliminate the possibility of a tax bill. When there are changes in the underlying holdings of an index, an index fund will have to make the same changes, and that can lead to a tax bill for shareholders if any holdings are sold at a gain that are not offset by losses. But changes due to “index rebalancing” are infrequent in large, market-tracking indexes and typically represent a small portion of a fund’s assets.

For many investors, however, the potential tax impact of investing in an active fund may be minimal. If the bulk of your investments are in a tax-deferred account like a rollover IRA, your account is immune from any tax bills generated by the fund from year to year. Your only tax bill comes when you withdraw your funds; if you happen to be invested in a Roth IRA, you may be able to avoid the tax bill completely.

When your money is invested in a taxable account, you could be hit with a tax bill every year. But fund managers aren’t oblivious to the tax implications of their trading, and often seek to offset any potential capital gains for shareholders with any realized capital losses. Many actively managed funds are just as tax-efficient as an index mutual fund.

What’s most important is not the size of your tax bill, but how good your fund is at producing strong after-tax returns. If you own a fund that avoids generating a tax bill but doesn’t have strong performance, what good does that do you? Conversely, an index-beating fund manager who generates a tax bill from time to time is still giving you superior after-tax returns. What you’re left with after taxes are paid is what matters most.

The Adviser Investments Perspective

At Adviser Investments, we are in the business of finding portfolio managers we believe have the talent to outperform their benchmark indexes. Our investment professionals rely on our in-house research team—led by Chairman Dan Wiener and Chief Investment Officer Jim Lowell—to identify managers who have added value over time. We believe that it is indeed possible to consistently do better than an index-only passive approach.

While the bulk of the over $5 billion we manage for more than 3,500 clients (individuals, trusts and institutions) is invested in actively managed funds, we build personalized portfolios from the bottom-up using our preferred actively managed mutual funds, index funds, ETFs or individual bonds or stock investments.

For example, if we want exposure to a specific asset class and have not identified an active manager running a fund in that space whom we have strong conviction in, we will consider using a low-cost ETF or index fund instead. Moves like this allow us to act on our investment outlook while also lowering the overall cost of investing for our clients.

And for our most cost-conscious clients, we also run custom ETF-only strategies derived from the insights we glean from our chosen active managers.

Analyzing and Monitoring Active Managers

Our approach is to dig deep beyond the surface of recent performance to unearth the truly talented portfolio managers who have a history of delivering strong risk-adjusted performance for shareholders. Our research is centered on the following beliefs:

• We Focus on the Manager, Not the Fund. There are no great funds, but there are great fund managers. That’s an important distinction. It does you no good to invest in what looks like a great fund based on recent performance if the manager responsible for that return has since left the helm. Conversely, if a talented manager takes over a mediocre mutual fund, it can create a great investment opportunity. That’s why, at Adviser Investments, our mantra is Buy the Manager, Not the Fund®.
• We Rely on In-Depth Return Analysis. Published fund performance statistics are simply snapshots of arbitrary time periods; say, the past quarter, year or five-year stretch. Adviser Investments believes a far superior method for evaluating a manager’s talent is to look at performance over multiple rolling periods, giving us dozens of data points to assess rather than one static beginning and end date. We also compute a fund’s worst return—we call it maximum cumulative loss—so we have a clear sense of how well a manager weathers down markets. One of the most overlooked contributors to long-term outperformance is how well a fund manager is able to reduce losses in a falling market.
• We Avoid Index Wannabes. It makes little sense to invest with an active manager whose portfolio closely tracks a benchmark’s; if the manager is just going to shadow dance with an index, we would be better off in a lower-cost index mutual fund or ETF. That’s why we use a number of measures to see how similarly funds have performed to their benchmarks over time—this list includes relative return plots, correlation and r-squared, among others. We’re looking for managers who can generate periods of outperformance by running portfolios that behave differently from their benchmarks.
• We Measure Relative Risk. At Adviser Investments, a strong return is not enough to catch our interest. We insist that a fund manager produce a return that compensates our clients for the risk (volatility) that the fund incurred along the way. Studying a fund’s volatility relative to the stock market is an important step in determining if the fund has a solid risk-reward profile. We invest with an eye toward outperforming over a full market cycle. This means we particularly want outperformance in down markets.  The larger the loss, the greater the return necessary to get even again. Our goal is to keep those losses within reasonable limits relative to the returns the manager can generate in up markets.
• We Get Personal. Statistics are important, but when you are handing your money over to an active portfolio manager or team of managers, it also is imperative to know the people actually running the fund. At Adviser Investments, we conduct intensive manager interviews so we can have a deep understanding of their investment philosophy and their approach to handling our clients’ money. We also like to find out whether a manager has any of his or her personal money invested in the fund. We believe a manager who “eats her own cooking” is extra motivated to do well when she is not just the manager, but a fund shareholder as well.
• We Start With Vanguard and Fidelity. Adviser Investments has built its business on our experience researching and dissecting the Vanguard and Fidelity mutual fund firms. We believe that by focusing on Fidelity and Vanguard, our clients have access to talented and experienced portfolio managers, deep research teams and the scale to keep costs low. While the bulk of our assets are invested with these two major fund firms, we use other fund families as well, and are comfortable going anywhere, any time.
• We Know When to Be Passive. As mentioned earlier, we use index funds and ETFs when we believe they represent a better investment choice than an actively managed fund. This is sometimes the case with international funds, especially in emerging markets, or for clients who wish to devote a portion of their assets to a specific market segment, such as gold, energy or commodities. While there are literally thousands of ETFs available to investors, many of which presume to track the same market segments, their underlying holdings and industry concentrations can vary dramatically. In addition, some indexes use market capitalization to determine how to “weight” the stocks in their portfolios while others use dividend yield, price-to-earnings ratio or even equal-weighting strategies to build their funds. We understand the differences and make sure we aren’t investing in a “faddish” or poorly conceived index-tracker.

The bottom line for Adviser Investments is your bottom line. We believe that there is a place for both indexing and active management, mutual funds and ETFs in building a strong, diversified and steady portfolio for clients of all investment objectives. We would be happy to discuss our investment philosophy, our work with individuals, trusts and institutions, and how we build customized portfolios with you.

For more information, please contact Adviser Investments at (800) 492-6868 or info@adviserinvestments.com.

This material is distributed for informational purposes only; and is not financial or investment advice. Speak to your financial adviser before taking specific action. The investment ideas and opinions contained herein should not be viewed as recommendations or personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed.

Our statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. You may request a free copy of the firm’s Form ADV Part 2, which describes, among other items, risk factors, strategies, affiliations, services offered and fees charged.

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