What’s the difference between active and passive investing? Why does SFG prefer active? We often hear these questions when discussing our investment managers and strategies with clients – and understandably so. As actively managed exchange-traded funds (ETFs) and mutual funds (MFs) have underperformed over the past decade, we’ve seen explosive growth in passive ETFs and a dramatic shift of assets into index-matching instruments (see chart below).
Total Assets in Active and Passive MFs and ETFs and Passive Share of Total
The active versus passive investing debate is not new. Over the past 10 years, a majority of actively managed funds have underperformed their respective benchmark (see chart below). We believe the current period of passive dominance has been mainly due to 10 years of dovish Monetary policy, which has helped extend the bull market beyond normal valuation metrics. In a market environment with low-interest rates, low volatility, and a narrow disparity between winners and losers, active managers are finding it difficult to add value. However, in a market with rising interest rates and increasing volatility, we believe the disparity between winners and losers will likely widen, creating a historically favorable environment for active managers.[i]
At the end of the day, active and passive funds move in cycles, with one typically outperforming the other at any given time since 1970. Therefore, it is prudent to have both in a diversified portfolio, depending on the investment strategy. The question then becomes, “what investment categories have historically performed best when actively managed versus their respective benchmark?”
Our research found that the type of information used to compare actively managed funds to benchmarks can cause performance numbers to vary greatly over various time periods. For example, the chart below compares the top three quartiles of active funds versus their respective benchmarks over 10-year rolling periods from January 1999 through December 2018 (121 time periods). Only those managers in the top three performance quartiles were included because the bottom quartile of poorly performing funds was unlikely to attract significant investment flows.[ii] The results showed that the top 75% of “Active Managers outperformed their respective indexes after fees more than half the time in all nine categories, with managers in seven categories beating the index in at least 65% of the 121 measurement periods”.[i] This suggests that actively managed funds tend to outperform their respective indexes when analyzed over multiple market cycles. At SFG, we share this opinion.
Percent of Active Funds by Category Outperforming Its Index After Fees Over Rolling 10-Year Monthly Returns
An actively managed fund has the ability to make specific investments aimed at achieving specific goals, such as outperforming a benchmark, preserving capital, or managing risk.
Our approach is to identify and select active managers in each asset class who can execute specific investment strategies. To select managers who meet our criteria, we’ve dedicated ourselves to conducting due diligence, monitoring and vetting managers, and performing scenario analyses.
The managers we have chosen are not “closet indexers” who claim to be active but whose portfolios closely mirror their benchmarks. These active managers have demonstrated a disciplined process for selecting only securities that meet stringent criteria, such as a strong competitive position, growing intrinsic value, experienced management partners, and free cash flow. In addition, these managers may maintain cash reserves, meaning they can act as liquidity providers in the event of a market correction.
Investment managers may exercise various degrees of active or passive investing. Through our extensive due diligence process, Schultz Financial Group Inc. seeks to identify and recommend the highest quality active managers. Then, we build your portfolio with these managers, based on your goals and objectives. Finally, we continue to identify, monitor, and evaluate managers according to our investment philosophy.
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Schultz Financial Group Inc. (SFG) is a wealth management firm located in Reno, NV. Our approach to wealth management is different from many other wealth managers, financial advisors, and financial planners. Our team of fee-only fiduciaries strives to help our clients build their wealth across four capitals: Financial Matters, Physical Well-being, Psychological Space, and Intellectual Engagement. We provide family office and wealth management services to clients located in Nevada, California, and other states. If you’d like more information, please check out our website or reach out to us via our contact page.
Schultz Financial Group, Inc. (“SFG”) which is a registered investment adviser, drafted this blog post for its website and for the use of its clients or potential clients. Any other distribution of this blog post is strictly prohibited. Registration as an investment adviser is not an endorsement by securities regulators and does not imply that SFG has attained a certain level of skill, training, or ability. While the content presented is believed to be factual and up to date, it is based on information obtained from a variety of sources. SFG believes this information is reliable, however, it has not necessarily been independently verified. SFG does not guarantee the complete accuracy of all data in this blog post, and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of SFG as of the date of publication and are subject to change. This blog post does not constitute personalized advice from SFG or its affiliated investment professionals, or a solicitation to execute specific securities transactions. SFG is not a law firm and does not intend for any content to be construed as legal advice. Readers should not use any of this content as the sole basis for any investment, financial planning, tax, legal or other decisions. Rather, SFG recommends that readers consult SFG and their other professional advisers (including their lawyers and accountants) and consider independent due diligence before implementing any of the options directly or indirectly referenced in this blog post. Past performance does not guarantee future results. All investment strategies have the potential for profit or loss, and different investments and types of investments involve varying degrees of risk. There can be no assurance that the future performance of any specific investment or investment strategy, including those undertaken or recommended by SFG, will be profitable or equal any historical performance level. Any index performance data directly or indirectly referenced in this blog post is based on data from the respective copyright holders, trademark holders, or publication/distribution right owners of each index. The indexes do not reflect the deduction of transaction fees, custodial charges, or management fees, which would decrease historical performance results. Indexes are unmanaged, and investors cannot invest directly in an index. Additional information about SFG, including its Form ADV Part 2A describing its services, fees, and applicable conflicts of interest and Form CRS is available upon request and at https://adviserinfo.sec.gov/firm/summary/108724.