Swedroe: Active Won’t Save Your Retirement

November 13, 2017

Russell Investments is one of the largest asset managers in the world. Morningstar reports that, as of the close of July, it had more than $41 billion in assets under management.

However, the firm’s impact goes well beyond its AUM; Russell is one of the largest players in the world of investment consulting. It provides consulting services to pension plans and other institutional investors, as well as advice to investment advisors on selecting the best active managers.

An Argument For Active

Jeff Hussey, Russell’s global chief investment officer, in a piece titled “Active, Passive and the Low-Return Imperative,” argued that, given the current high valuations for equities and, thus, low forward-looking return expectations, he believes investors “cannot afford to ignore any investment strategy that may offer incremental return, take on risks they do not expect to get paid for or disregard implementation efficiency.”

He writes: “So many investors are currently focusing on reducing fees as a way to potentially increase the actual performance received. But prioritizing fees can cause investors to rotate out of actively managed investments into passive ones—thereby decreasing the likelihood of achieving anything more than the index-based return.”

He adds: “Passive investing alone will never outperform the market. If the markets are performing very well, then passive may be the best way to go. But what happens when markets are in a low-return environment like they are today?”

Hussey then offered three suggestions:

  • “Net-of-fee alpha from active management—Passive, by its nature, will underperform the market—because it tracks the market, but then includes fees. It cannot beat the market. And any exposure to the market includes exposure to risk. Active management, while it also inherently includes risk and fees, provides the potential for outperformance….
  • Targeted exposures—Delivering on investor outcomes in a low-return environment requires access to more exposures, not less. But we believe gaining access to precise exposures at the right time requires skill. And we believe that these niche market segments—such as infrastructure, emerging markets, and commodities, among others—lend themselves to providing potential opportunity when gauged through the lens of highly specialized active managers.
  • Dynamic asset allocation—Constantly managing exposures and allocations requires a deep understanding of global markets and cycles, but it also requires 24/7 focused commitment. Be sure that your investment solutions provider has the trading and implementation capabilities to potentially take advantage of tactical upside opportunities and minimize unrewarded risk.”

Debunking The Claims

There’s nothing new about these types of claims. You hear them all the time from active managers. But do they contain any real truths?

To investigate that question, I’ll offer a different perspective on these assertions, and provide the appropriate historical evidence, so you can draw your own conclusions. I’ll begin with Hussey’s assertion that rotating out of active management reduces the likelihood of achieving anything more than the index return.

While that statement is correct, I believe it’s a deflection. What it’s deflecting is that, historically, rotating out of active management actually has increased the likelihood you will outperform the active strategy, as the S&P Dow Jones Indices Versus Active (SPIVA) scorecards regularly show.

As further evidence, I offer the following table, which shows the performance rankings of two of the leading providers of passively managed funds, Dimensional Fund Advisors (DFA) and Vanguard, for the 15-year period ending in 2016. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends DFA funds in constructing client portfolios.)

Data is from Morningstar, but it has been corrected for the survivorship bias in their rankings. (The rankings you see on Morningstar’s website unfortunately show performance relative only to those funds still in existence at the end of the period.

For example, let’s say a given category had 100 funds at the start of the 15-year period and only 50 funds at the end of it because some were closed or merged into others, which we can assume was the result of poor performance. The way Morningstar calculates their rankings, the 10th-best-performing fund in this category over this period would have a 20th%ile ranking because it ranked 10th out of 50 funds.

Correcting for survivorship bias means accounting for all the funds in the category an investor could have chosen at the beginning of those 15 years. It would give that same fund, with the same performance and over the same period, a 10th%ile ranking because it now ranks 10th out of 100 funds.) 

 

 

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