by Maz Jadallah

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The active vs passive debate continues unabated in the financial media.  Passive strategies continue to accumulate assets while active strategies lose them causing many to proclaim that active investing is dead.  Let’s take a step back and try to separate reality from hype.

Despite passive’s impressive gains, the amount of assets being managed actively is still greater.  According to the Investment Company Factbook, at the end of 2017 there was approximately $12 trillion in actively managed mutual funds vs $7 trillion in index mutual funds and ETFs combined.  Add $3 trillion in hedge fund assets and you get about a 2 to 1 ratio of active over passive.  So at least historically, investors have had a real need for active strategies.  What was that need? Why has it changed? Will it change again in the future?  The answer to all of these questions can best be explained looking through the lens of one of the most enduring traits exhibited by investors – the fact they chase performance.

Passive strategy performance has been by far better than active performance since the financial crisis (see table below).  Believe it or not, investors over the past 10 years have enjoyed 4 in 5 odds that the S&P 500 returns 10% or more annually – the historical average (since 1949) is only 1 in 3, and the average during periods of increasing interest rates (like now!) is even worse at 1 in 5.  So when the S&P 500 is at its historical return average (6-8%/year) or less, investors apparently want to try and do better.  Conversely when returns are 10%/year or greater investors don’t see as much of a need for active.  The key question then becomes – will 10%+/year US market index fund returns continue for the foreseeable future?

Perhaps recognizing the ominous signs of lower future market returns, #Vanguard (the kings of passive investing) and #Morningstar have weighted in on the need for balance between active and passive strategies in a portfolio.  The prevailing wisdom is that investors should seek some exposure to active strategies making sure to select lower fee funds since low fees are a strong predictor of future performance.

But which low fee active fund should investors select?  At the end of 2017 there were almost 19,000 mutual funds, 3,400 ETFs and at least 5,383 hedge funds. Screening for funds in the lowest fee quartile still leaves you with 5000 funds!  Manager/fund selection is perhaps the most difficult aspects of active investing – that’s exactly where AlphaClone can help.

AlphaClone’s investment approach seeks to solve the active manager selection dilemma.  Using mandated quarterly holdings disclosures by institutional investors (Form 13F-HR), we assess the stock selection skill of each manager in our universe every six months.  We then select the manager’s with the highest score and build portfolios based on their disclosed high conviction holdings.  Read “Clone Score – How We Pick Managers” for a deep dive into AlphaClone’s methodology.

While technically our strategies are characterized as passive because they are rules based, they can also be seen as quasi-active because we seek to identify and follow the high conviction investment holdings of the world’s most established active managers.  That’s why we like to characterize our strategies as “active indexes”.

We thought it would be instructional to look at performance results for five investment regimes that span the passive/active continuum.  Each approach seeks to gain exposure to US equities but in very different ways.  We define the five investment approaches as follows:

  1. Extremely passive: this approach will allocate to a single market cap weighted index that seeks to represent all US equities.  We use the Fidelity Total Market Index Fund (FFSMX).
  1. Passive: this approach divides US equities into two categories; large cap and small cap.  Our analysis assumes a 50/50 allocation between the iShares S&P 500 Index ETF (IVV) and the iShares Russell 2000 ETF (IWM).
  1. Active Index:  Our analysis assumes a 100% allocation to the AlphaClone Hedge Fund Master Index (ALFMIX) which can be accessed via our ETF.
  1. Active:  taking one step further towards active management we simply take the Morningstar US Large Blend category returns which represents the average return of all active mutual funds in that category.
  1. Extremely active:  finally, for the high octane set, we include an “extremely active” category represented by the HFRI Equity Hedge Index. The index represents the average returns for hedge funds that espouse and equity investment approach.

We calculate annualized returns through August 2018 and compare each investment approach across several time horizons.  The results are presented in the Exhibit 1 below – extremely passive is the left most bar (light grey), extremely active is the right most bar (dark grey).

A few things jump out from the exhibit above:

  1. Passive strategies have performed very well, especially over the three year horizon.
  2. Despite achieving returns that are double their historical average, the active index approach still managed to outperform the more passive approaches over the five year horizon.
  3. No investment strategy outperforms all the time – active indexing returns lagged over the 3 year period and passive strategies are beginning to lag more recently.

Active or passive represents a false choice to investors and their advisors.  A thoughtful combination of both passive and relatively low cost and efficient active investment regimes has proven itself over time to be superior to either passive or active strategies on a stand alone basis.

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