The real enemies in the active/passive debate are not those who take the opposite view, but the polarizing extremists.
This article first appeared in the June/July 2011 issue of Morningstar Advisor magazine. Get your free subscription today!
Active fund managers have been so effectively demonized by some members of the index community that even casual investors now cite the mantra that no active managers can beat the market. This false assumption is the reciprocal of the absurd glorification of fund managers that we saw in the 1990s.
The truth, of course, rests between the extremes: Active managers neither walk on water nor are they bumbling fools. My goal in this column, however, isn't to point out that the truth lies somewhere in the middle. Instead, I will focus on the damage that's done by our allowing the debate to become so partisan. The real enemies often are not those who take the opposite view, but the polarizing extremists, even those on our own side.
When we allow the discussion to be framed in black and white, we not only tarnish all of the opposing camp, but also we implicitly endorse all of the actions of those on our side. I wrote recently about how the pilgrimage toward passive funds has left many high-quality active funds in net redemptions. Index zealots will tell you that those are the costs of war and that all revolutions have casualties.
What they will have a harder time doing is defending the quality of the passive products that investors are marching toward. A stunning 38% of the open-end index funds that Morningstar tracks in the United States have Turnover rates of more than 100%. A quarter of U.S. open-end index funds have expense ratios of more than 1%. These funds have little, if any, claim to the tax efficiency and cost savings of indexing, yet they are gaining market share because they ride on the coattails of the indexing movement. The indexing pioneers, so quick to point out the flaws in active managers, have remained essentially silent on the sins committed by their own followers.
With the polarization of the debate comes its perversion. The case for indexing is to buy and hold the entire market at low cost. Yet, the vast majority of index funds today offer just some narrow slice of the market, tempting or requiring investors to mix, match, and trade these funds to achieve a reasonably diverse portfolio. How ironic that the latest craze in ETFs is to offer an ever-increasing number of free trades--the investment equivalents of free drink coupons at the casino. Cloaking frequent trading under the sainted cloth of indexing allows investors to feed their gambling inclination while still feeling good about themselves, much like gorging on diet soft drinks or low-fat desserts. Perhaps the best metaphor for ETFs isn't the finely honed shotgun that Jack Bogle famously suggested, but frozen yogurt.
The active/passive discussion isn't the first time the fund debate has been polarized. It happened with load and no-load funds, with similarly unfortunate consequences for investors. In the 1980s, a growing body of personal-finance writers made it their mantra that investors should only buy no-load funds, failing to appreciate that many investors wanted the professional advice that came with loads. By demonizing load funds, these writers drowned out the more important discussion about the risks and benefits of using an advisor versus going it alone. In its place were black-and-white rallying calls of "load equals bad, no-load means good," ignoring the truth that lots of great funds carried loads and plenty of stinkers were available no-load.
Demonizing the load/no-load debate led to the seemingly countless share classes investors must now wade through. As investors marched to their advisors, whose counsel they still wanted, and demanded no-load funds, the industry responded with B shares and C shares that left investors feeling good about themselves for having bought a "no-load" fund, but ironically paying as much, if not more, than they were before. The industry created the illusion that the services of a skilled advisor could be had for free--once again, the frozen-yogurt illusion of weight loss without diet or exercise. The unfortunate result of the overheated, partisan debate on loads was that a whole generation of investors focused on the costs of financial planning, not its benefits, a misstep the baby-boom generation is still paying for as it nears retirement without sufficient savings.
Allowing the debate to be framed as index versus active or load versus no-load crowds out a far more useful distinction, smart versus foolish. Even if you prefer index and no-load over their alternatives, being a blind cheerleader for your view can be an implicit endorsement of unsavory practices. Collectively, we'd be better off if the partisan energies were redirected toward rooting out bad behavior on either side. Investors' real enemies aren't quality load funds or low-cost active funds, they're inefficient funds that lead to bad investor outcomes, and those funds can come in all kinds of wrappers--load, no-load, index, active, and alternative.
Don Phillips is Morningstar's president of fund research.
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