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A Twisted Debate

Active versus passive is largely a smokescreen.  Here's what matters most.

Don Phillips, 02/13/2013

The active-versus-passive debate has been grossly overplayed to the detriment of many fine, actively managed fund shops and to intelligent investment discourse. Index proponents—usually with an index-based strategy to sell—have improperly intertwined a robust case for low-cost strategies over high-cost ones with the more tenuous case for passive over active. At their most corrupt, these index proponents wrap their own high fees around an index-based strategy and portray their activities to the media and public as being morally superior to strategies using active funds. If you want a list of some of the worst offenders, just check the bookshelves in the finance section at your local library. Let’s examine the facts.

Although the public perception that all active managers trail the market is false, it is true that the decision to index tilts the odds in the investor’s favor. As the chart above shows, moving to index strategies would improve the trailing percentile rank in category numbers from an average of the 50th percentile to the 42,nd 40,th and 47th for the trailing three-, five-, and 10-year periods. That’s a meaningful benefit. But as seen in the next column, a similar or even better advantage can be obtained with actively managed funds if one simply restricts purchases to funds with expense ratios below their category average. What’s more, if one adds just one more screen and chooses among actively managed funds with both below-average expense ratios and manager investment of more than $500,000 in their funds, the odds begin to favor actively managed funds over index funds. So much for the magic of indexing. With two simple screens, investors can do as much, if not more, to put the odds in their favor than they can by restricting their choices just to index funds. While these numbers are not adjusted for survivorship bias, doing so wouldn’t change their basic premise.

In fairness, these numbers speak more to the corruption of retail index fund offerings than they do to any flaws in the academic case for indexing. The average index fund has a net prospectus expense ratio of 0.79% and a gross prospectus expense ratio of 1.27%. It also, stunningly, carries an annual turnover rate in excess of 100%. The core benefits of indexing are no longer represented in the majority of index funds available today. The amount of embarrassing behavior going on under the index umbrella has severely tarnished claims for the moral superiority of indexing.

Jack Bogle, to his credit, has long acknowledged these issues, at one point simply saying that the whole case for indexing falls apart if not prefaced by the words “low cost” and “no load.” Vanguard’s low-cost index funds compare quite favorably to those of the low-cost active managers with skin in the game. Focusing just on Vanguard’s index funds clearly would do much to tilt the odds in the investor’s favor. But so, too, would restricting oneself to Vanguard’s actively managed funds, which score similarly, if not better, than Vanguard’s index funds! And these numbers, owing to Vanguard’s infrequent merging or liquidating of funds, have little if any survivorship bias.

Clearly, indexing is not the sole or even the primary path to better odds of investment success. The over-the-top case for indexing in favor among the press, some regulators, and many advisors does the public a disservice. It perpetuates false stereotypes. Not all index funds are good, not all active funds are bad. The focus instead should be on low cost versus high cost. The cause of passive’s collective advantage over active is not manager ineptitude; it’s essentially just cost. Lose the cost benefit, and you lose the advantage. Active versus passive is largely a smokescreen; it’s low cost that matters most. Intelligent investors should feel free to fish in either the active or the passive ponds, but they should be vigilant in avoiding high-cost options from either.

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Don Phillips is a managing director of Morningstar, Inc.

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