Fighting the Right War

The debate between active and passive management has enriched many academics, advisors, and asset managers who were quick to jump on the indexing bandwagon, but a case can be made that this overhyped discussion has done a disservice to investors on the whole. That doesn’t mean indexing isn’t a fine way to invest. It is. But as indexing marches ever closer to being viewed by advisors and regulators as the only defensible means of discharging a fiduciary obligation, we should be honest about how we evaluate its comparative merit. I see three issues: 1) the mathematical case supporting indexing, while correct at its core, is regularly and often purposely overstated, 2) the theoretical debate between active and passive is largely irrelevant to the choices most investors make, and 3) the active/passive debate distracts attention from the real roadblock investors face, which is assembling better portfolios.

Let’s start with the skewed comparison that fuels the debate: how well the average manager fares relative to the index. This battle pitches the paragon of indexing—a theoretical, no-cost, broad market index—versus an equal-weighted, real-world average of all managers investing in the same space. By definition, the average manager always loses out. But this comparison tells us less about the superiority of indexing than of the inferiority of real-world averages. The average actively managed fund is ugly. So, too, however, is the average index fund.

The average of the 593 U.S. equity index funds Morningstar tracks has an expense ratio of 1.23%. Nearly one in six of those funds has a turnover ratio of more than 100%. On average, these index funds have trailed the theoretical S&P 500 Index by 2.06% per year over the past three years and 1.58% per year over the past five. The real-world average of almost anything is an ugly thing. By this math—the same math that “proves” the inferiority of active managers—the “average” index fund can lay claim to neither low cost nor tax efficiency.

Index champions will argue—correctly—that no one buys the average index fund and that most assets go to bigger, better index funds. That’s completely true, but the same is true for actively managed funds, where assets have long flowed to lower-cost managers with better returns, a point that index proponents seldom concede in bashing active management.

From this flawed analysis has emerged the new conventional wisdom that investors are wiser to build portfolios from index funds than from active ones. But, as we’ve shown in this column before, if one makes just two simple screens among active funds—to look for those with below-category expenses and ones where management invests its own money in the fund in a meaningful manner—the superiority of indexing falls away. One can build a fine portfolio out of either low-cost index funds or well-managed, low-cost active funds. Put another way, Vanguard’s active funds are as good a hunting ground as the firm’s passive funds. Thus, the whole bifurcation of active-versus-passive has been more for the benefit of the manufacturers of passive products than for the utility of investors.

But by far the most unsettling point of this whole debate has been the attention it has taken from the mission-critical task facing investors, which is portfolio assembly. In recent decades, investors have increasingly bought good funds. Assets flow to lower-cost, better-performing, lower-risk funds. That’s why asset flows correlate well with Morningstar star ratings. The problem is that people buy good funds, but assemble bad portfolios. They overreach on areas that have been hot in the recent past, and they abandon asset classes that have been out of favor. This is true for users of both active and passive funds. Debating the preferred vehicle is entirely beside the point. It’s not the type of fund, but the portfolio assembly that investors mess up.

Fortunately, amid all the inflated rhetoric of active/passive, there’s been a sea change in the way asset managers bring their services to market in recent years. Most significantly, they focus on selling through advisors who construct client portfolios. In addition, target-date funds and so-called robo-advice services offer investors preassembled packages of funds, promoting better fund usage. As we’ve noted, target-date funds have smaller gaps between time-weighted and dollar-weighted returns, suggesting investors deploy them more successfully than they do most offerings. This narrowed gap benefits everyone in the process, as no one wins if the investor fails. Managed accounts in the retirement space make a similar, but more customized contribution to this effort. And now, robo-advice is reaching out to a wider audience to help people build better portfolios.

To date, many robo-advice offerings have focused on index funds as their building blocks, as indexing has won the current public relations battle, but there’s no reason quality actively managed funds can’t be part of the solution, as they surely will be as more actively managed fund shops launch their versions of robo-advice to aid advisors and investors. To date, also, the advice has been fairly simplistic and uniform—much ado about 60/40—as it’s largely derived from a uniform academic school of asset allocation. This, too, will grow more sophisticated, providing some better outcomes (and some inevitable missteps).

The important thing is that the game is shifting from fund selection to portfolio assembly. That’s where it must go, as that’s where investors’ needs are. Active/passive has been an overhyped sideshow. Disciplining investors to hold out-of-favor assets, to not chase hot products, to rebalance, and to maintain contributions in tough times—the things a good advisor does—these are the things that ultimately determine investor success. We are all in the behavior modification business. Which types of funds we use to enact that behavior should be a secondary concern, not the centerpiece of the debate as it has been for far too long.

This article originally appeared in the June/July 2016 issue of Morningstar magazine.