Active No Longer The Default

September 13, 2017

This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Michael McClary, chief investment officer of Akron, Ohio-based TOPS ETF Portfolios.

For more than 75 years, traditional active management has been the default option for investors. From the 1920s and ’30s, when direct stock and bond selection was the only option, through the Investment Company Act of 1940, investors have defaulted to traditional active management.

Active management has had a strong emotional hold on investors. The idea that investors can pay more money to someone with significant education and experience to provide better returns just makes sense.

One popular American saying is, “you get what you pay for.” In the case of investing, the mantra has been to pay more for more return.

Even though index investments were first mainstreamed in the 1970s and ’80s, the active management head start has been very strong. It has taken four decades for index investments to finally dethrone actively managed funds as the default option for investors. And while the transition is still occurring, the trajectory and direction are not reversing.

I oversee several billion dollars in active management, as well as our $5 billion in ETF assets. Much of the actively managed assets are legacy positions accumulated by investors over the 54-year history of our firm.

I do not dislike active management. On the contrary, I would love for active management to deliver extra return as promulgated. However, I recognize we are likely to have fewer assets in active management 10 years from now than we have today, as active management is no longer the default option for investors.

In this article, I will address issues affecting the transition of assets to index investments.

Reason Leads To Conclusions, Emotion Leads To Action

Donald Calne, a leading neurologist, is credited with saying “The essential difference between emotion and reason is that emotion leads to action, while reason leads to conclusions.”

The logic behind index investing is strong, and I would argue, conclusive. In the following chart, the key results from the most recent S&P Index Versus Active (SPIVA) report are shown.



For a larger view, please click on the image above.


Sources: S&P Dow Jones Indices LLC. SPIVA U.S. Scorecard Year-End 2016. The S&P 500 is a capitalization-weighted benchmark that tracks broad-based changes in the U.S. stock market. The S&P MidCap 400® provides investors with a benchmark for midsize companies. The index, which is distinct from the large-cap S&P 500®, measures the performance of midsize companies, reflecting the distinctive risk and return characteristics of this market segment. The S&P SmallCap 600® measures the small-cap segment of the U.S. equity market. The index is designed to track companies that meet specific inclusion criteria to ensure they are liquid and financially viable. The S&P 700 measures the non-U.S. component of the global equity market through an index that is designed to be highly liquid and efficient to replicate. The index covers all regions included in the S&P Global 1200 except for the U.S., which is represented by the S&P 500®. The Barclay’s Long Term Government/Credit Index includes publicly issued U.S. Treasury debt, U.S. government agency debt, taxable debt issued by U.S. states, territories and their political subdivisions, debt issued by U.S. and non-U.S. corporations, non-U.S. government debt and supranational debt. One cannot invest directly in an index. Indices are unmanaged and do not incur fees.,span>


Specifically, the table shows the percentage of actively managed mutual funds that have underperformed their benchmark indexes over varying time periods. Every six months, S&P compares active managers to indexes. These reports can be accessed here as well.

Bringing up the SPIVA report to active managers is a sore subject. After reviewing the information, along with the accompanying S&P Persistency Scorecard, any logical investors would have to conclude indexes may provide a better statistical chance for success.

However, investors need to make the emotional decision to sell their active funds and buy indexes. While logic can contribute to emotion, other emotional factors can overpower logic. Just ask any teenager about the last 10 decisions they have made.

To make the emotional decision harder, some active managers have tried to confuse the logic.

Studies have been released by active managers that effectively show, "If you screen the returns for only Tuesdays in the fall on days when it isn't sunny and close your left eye, active funds outperform."

Sure, there will be some funds that outperform in each year. However, the S&P Persistency Scorecard shows almost no funds consistently outperform over time. Likewise, the deck is stacked heavily against the odds for the average active manager to outperform indexes over time. Further, there is no sure-fire way to decide ahead of time which manager will be above average.


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