Which is better, active, or passive fund management? In some circles, that question is as contentious as politics. Instead, there is a better question to ask. When is the best time to use each investment style? In the right situation, active management can shine. And in the appropriate circumstance, passive management works well too. By and large, after looking at the reality of active and passive fund management, there is a third alternative, direct index investing. This strategy blends concepts from active and passive investment styles. Also, direct indexing does have some unique features that set it apart from active or passive fund management. Plus, like anything else in life, there are pros and cons
This is a disclosure
Before going further, it is essential to point out that investing does involve financial risk. This information is not financial advice. Past performance cannot be a guarantee of future results. Before you invest read the disclosures to understand the risk and cost.
Let’s have a common understanding
Let’s get on the same page. In general, there are three options we are discussing, active fund management, passive fund management and direct index investing.
Active fund management
Active fund management is where a portfolio manager or a portfolio management team actively buys and sells securities. Consequently, some people would say that the objective of active fund management is to beat the market. That may be true at times, but not always. Sometimes the aim of the portfolio manager is to manage risk. Sometimes the objective is to create income. And at times, the portfolio manager’s job is to pick investments based on principle-based goals like ESG or biblical responsibility. Accordingly, the investor’s personal intent is the first consideration when selecting any investment style.
Passive fund management
Passive investing is often related to duplicating an index. An index is a group of securities that is intended to be like a particular area of the market. There is no management beyond owning the investments in the index. But that is where there is a considerable misconception exists.
Passive investing with an index does not mean that there is no activity in the portfolio. Yes, there is no guesswork when picking stocks or other securities. However, the securities within an index do change. As an example, look at the changes within the Russell 2000 from June of 2017.1 This is reconstitution.
- The Russell 2000 added 228 companies
- 137 companies left the index
- 42 companies entered the index by moving down from the large-cap Russell 1000 Index
- 115 companies entered the index by moving up from the Russell Microcap Index
- 31 companies exited the index by moving up into the Russell 1000 Index
- 26 companies left the Russell Index universe altogether2
If you owned an index fund that tracked the Russell 2000 then, your portfolio changed substantially over that year. Plus, you have no control over which stocks are added or taken out.
Sailing takes me away!
“Sailing takes me away to where I’ve always heard it could be,” are the lyrics from the 1980 song by Christopher Cross3 In a way, that song describes how an index fund functions. Passive investing is like jumping into a sailboat with no rudder and saying take me someplace. If your objective is only to sail, that is OK. You got what you wanted. Don’t take me wrong. There are some circumstances where this style of investing works better than others. We’ll look at that in a moment.
But when you buy an index fund, you must be willing to accept the results of the index regardless of your tax status, regardless of your risk tolerance and irrespective of your morals and beliefs. For some people, that is precisely what they want, and that is OK.
Direct indexing, the third option
The third option is investing directly in an index. However, let’s be clear. If you want to duplicate an index, it is not always only buying one share of each stock. Direct indexing is not a black box strategy.
How the stocks of an index fund are purchased depends upon how the index is valued. For example, the S&P 500 is organized based upon the value of the companies within the index. This is called their capitalization. So, buying one share of each stock in the index would not duplicate the performance of the index. Here is what you would need to replicate the performance of the index. You would need to own the same proportions as the index.
For example, the S&P 500 index is put together based on company valuations. The index is dominated by tech companies. “Apple, Microsoft, Alphabet, Amazon, and Facebook now account for 17.5% of the S&P 500.”4 This large of a percentage in tech stocks creates a high exposure to one sector, the tech industry.
In some situations, this is OK. But if you are worried about the risk of overweighting in one industry, direct indexing allows you to reduce that exposure.
4 unique direct index features
Here are some unique features for passive investors using direct indexing.
- If those using direct indexing feel overexposed to tech companies, they can reduce the allocation based on their preferences.
- Remember the reconstitution of an index mentioned before? Reconstitution can cause unwanted capital gains, even for new investors. You can avoid the tax effects of reconstitution by buying the stocks directly.
- Mutual funds and ETFs cannot sell stocks to take advantage of tax losses. Conversely, direct indexing allows investors to sell any individual stock that may have a tax loss.
- Direct indexing allows investors to NOT buy stocks of companies that operate contrary to their morals and beliefs.
Three must-haves for direct indexing
There are three must-haves to make direct indexing affordable and functional. First, any business that offers direct indexing should have commission-free trading. In current times, you can own a share of every stock in the Russell 2000 index for between $15,000 and $16,000. But, if you have to pay for over two thousand trades, the cost would be ridiculous.
Second, allowing investors to buy fractional shares allows smaller investors to have the buying power of a large institution. Even if you had $100,000 to invest, you would not have enough to get adequate index representation in most major indices. Here is what I mean. Consider indices that are organized based on a company’s total value. Each company in value-weighted indices will have a percentage of the index-based upon its value. Owning fractional shares allows a passive investor to buy the correct proportion of stocks to mirror any index.
The third must-have for direct indexing is tax analysis technology. Let’s assume that you want to pay less taxes. If you passively own many stocks from an index, you will have some losses. In short, it is inevitable. You can’t have all winners. To take advantage of the tax losses, you need to be able to analyze many stocks. Therefore, the investment custodian you use must have the technological ability to analyze many stocks to show losses.
What studies say
Now that you have an understanding of how the three investment styles work, let’s look at what a study of passive and active management says. The research that I am referring to was done by Dr. Alexey Panchekha, CFA, in 2019. It is called “The Active Manager Paradox: High-Conviction Overweight Positions.” 5 If you’re into statistics, it’s an interesting read. The study is free to read. Given that, A link to the study is in the references at the end of this article. This is the bottom line I gathered from the study.
Large-blend active managers have outperformed the S&P 500 in only 5 of the 29 years analyzed. On average, active managers underperformed by –1.7% per calendar year.4
But there are circumstances where a managed fund may be more appropriate. Dr. Panchekha further showed that concentrated funds outperformed that market benchmark 74.1% of the time by 2.82% in rolling one-year timeframes. 4 He refers to concentrated funds as portfolios, where an active fund manager has high conviction in their selections. An interesting aspect of these numbers is the way he reported the findings. He stated the results after a 0.85% fee was included.
What’s the meaning?
Until someone invents the time machine, we cannot tell what is going to happen in the future. However, a one-way look at this information is from a historical perspective. Large blended funds have a meager history of beating the indices. Plus, highly concentrated funds have historically been able to outperform indices. But wait! I know I’ve said this before. But, the past performance of an investment is NOT a guarantee of future results.
What about the fees?
Dr. Panchekha analyzed the fees of funds in his study too. He said, “While it is industry convention to blame these outcomes on higher fees, our research suggests that fees are only a secondary contributor.” 4 The report showed active managers, who diversify too much, lagged the indices. That leads to one of the features of direct indexing, smart beta. We’ll cover smart beta in a moment.
What about direct indexing?
Previously, we discussed four unique features of direct indexing.
- Allocation reduction
- Avoiding reconstitution
- Using tax losses
- Allows principle-based focus
However, direct indexing can also amplify an aspect cited in the previous study. Direct indexing can focus on concentrated factors. Direct indexing can filter out investments from specific sectors, investments with no growth history, or a multitude of other factors.
Its like football
Imagine a football team that is trying out four quarterbacks in the preseason. They play four preseason games. The coach lets a different quarterback play each game. The coach looks at the stats. He looks at attempted passes and completions. Then he considers the average yards per completed pass and the number of touchdowns. Finally, he looks at the number of interceptions. The quarterback with the best statistics is named the starting quarterback for every game.
Direct indexing can use statistics like a football coach. But with direct indexing, the financial advisor uses factors to filter out less desirable stocks and emphasize stocks with pre-determined characteristics. Those characteristics can be economic, risk-oriented, or principle-based.
I do use all three styles of portfolio management in my practice. The end recommendation depends upon the clients, needs, desires, and risk tolerance. Would you like to talk about how the information I’ve covered could be used in your situation? You can have a free conversation with me by going to my website at RichardsFinancialPlanning.com and sign up for a time to speak.
1 Agather, Rolf. “FTSE Russell announces Schedule for annual Russell US index reconstitution.” FTSE Russell. Last modified March 3, 2017. https://www.ftserussell.com/press/ftse-russell-announces-schedule-annual-russell-us-index-reconstitution.
2 John Hancock Investment Management. “Why index reconstitution matters.” John Hancock Investment Management. Last modified June 29, 2018. https://www.jhinvestments.com/viewpoints/etfs/why-index-reconstitution-matters-to-your-portfolio.
3 Cross, Christopher. “Sailing.” Christopher Cross Official Website. Last modified June 1980. https://www.christophercross.com/music.
4 Konish, Ari L., and Lorie Konish. “The five biggest tech companies now make up 17.5% of the S&P 500.” CNBC. Last modified January 28, 2020. https://www.cnbc.com/2020/01/28/sp-500-dominated-by-apple-microsoft-alphabet-amazon-facebook.html.
5 Panchekha, Alexey. “The active manager paradox: high-conviction overweight positions.” CFA Institute Enterprising Investor. Last modified October 3, 2019. https://blogs.cfainstitute.org/investor/2019/10/03/the-active-manager-paradox-high-conviction-overweight-positions/.