Our Thoughts on Burton Malkiel's Article on Active vs. Passive Investing

Is indexing better than active management? How does CornerCap active management compare?

In the May 28, 2013, Wall Street Journal, influential economist Burton Malkiel wrote an op-ed entitled “You’re Paying Too Much for Investment Help.”  Several clients have asked us to comment.

 By way of background, Malkiel wrote the seminal book A Random Walk Down Wall Street over 25 years ago (of which we are big fans), and this article follows the logic of that book.  In the article he describes how actively managed stock funds have underperformed passive index funds since 1980, largely due to fees.  He also points out two-thirds of active managers do not beat the market, and those that do tend not to do so consistently.  He concludes that “[y]ou can’t control what markets can do, but you can control the costs you pay” and that index funds “should comprise the core of every investment portfolio.”                                      

We’ll make three comments on Malkiel’s article.  The first two are simple and should be well known to clients, as they are core to our investment philosophy.  The third and more interesting point will focus on what is often perceived as the “religious war” between active and passive management.  Is one better than the other?  How does CornerCap active management compare?  Can we offer some real-life examples?

 Two Quick Points: Fees Are Destructive and Investment Discipline is Vital

 First, we definitively agree that fees are highly destructive to returns.  They are often hidden and can create conflicts of interest between investment managers and investors.  CornerCap is committed to minimizing their impact, by keeping fees reasonable, simple, and transparent.  Where appropriate, we use low-cost passive index funds in client portfolios.

 Second, like fees, emotions are equally destructive, but passive index funds don’t protect you.  Evidence overwhelmingly shows that most investors cannot follow an investment plan consistently, whether using active or passive investments.  Malkiel’s article omits this crucial point.  An actively managed investment discipline is fundamental for positive long term performance.

 The More Interesting Part: Active vs. Passive Management—Which Is Better?

 This is a hotly contested, age-old debate.  There have been numerous studies of active vs. passive over the years.  Malkiel makes the traditional argument for the passive side, and it clearly offers some advantages (fee reduction, improved tax efficiencies).  John Bogel built Vanguard on the concept of passive indexing strategies.  Malkiel’s firm, Wealthfront, also markets passive indexing strategies.

However, research has shown that active management can add value to portfolios—whether in less efficient markets (US small cap stocks or specialty niche areas) or by capitalizing on inevitable emotional extremes that passive index funds cannot recognize.  CornerCap’s philosophy is to seek “regression to the mean” when securities are mispriced.  We believe we can objectively recognize the extremes and put the odds in our favor for the long term; what we cannot predict is when the “return to normal” will happen.

 Ironically, although not mentioned in Malkiel’s article, academic research suggests that the performance of active and passive strategies tend to cycle around each other.  Each strategy experiences periods of relative outperformance and relative underperformance.  A successful long term portfolio strategy must follow a disciplined and repeatable process in order to outperform the market over time.  This means accepting that there will be periods when the strategy—whether active or passive—underperforms. 

 Beware “Closet Indexing” by Active Managers

 Periods of poor performance not only test the resolve of investors; they also stress the business model of the active manager.  Fund managers can experience large outflows of money when their strategies are out of favor.  To avoid this pain, active managers can “hug the index” so that they reduce their volatility.  The trade-off of course is that investors are paying them to quietly follow the benchmark.  By definition, due to fees, those active returns will underperform.

 An actively managed fund with portfolio holdings similar to the market index is commonly referred to as a “closet index fund.”  As Malkiel would agree, investors should avoid active managers who behave this way.

 Real Examples from the Tech Bubble

 To put these two observations (regression to the mean and closet indexing) in context, we reflect upon the late 1990’s, a time when passive index investing was difficult to beat.

 Technology stocks were driving the market and the percentage of technology stocks in the S&P 500 swelled to over 35% of the index.  The price/earnings ratio of the average S&P 500 stock rose to a historically high 30 times earnings.  Our research discipline of investing in stocks with low valuation multiples prevented us from investing in most of these technology names.  As a result, our returns did not keep up with the market.  The pressure to abandon our investment discipline was growing.  Clients were calling daily concerned about the performance variance.  Several of us at CornerCap learned the most important lessons of our careers: the CornerCap response to this pressure was to stay with the discipline.  Eventually, we were rewarded for staying the course with six straight years of significant outperformance.

 To illustrate with real numbers: During the tech bubble years (1998-1999), CornerCap’s Large/Mid-Cap Equity Composite gained a cumulative 15% gross returns (13% after fees), way behind the S&P 500’s returns of 56% for this period.  After the tech bubble burst and in its aftermath (3/31/2000-12/31/2006), the same composite posted gross returns of 92% (81% after fees), well ahead of the S&P 500’s 6%.  All-in, for the entire period, CornerCap posted 121% gains (105% after fees) vs. the S&P 500’s returns of 68%.  (Follow the link at the end of this article for more information and important disclosures regarding these returns.)

 We also recall what happened with two Fidelity mutual funds at the time, called Fidelity Destiny I and Fidelity Advisor Growth Opportunities.  Both funds were managed with value-oriented strategies by a seasoned portfolio manager.  At the height of the tech bubble, both funds were experiencing significant outflows as investors abandoned the funds for poor performance.  In February of 2000, Fidelity decided to replace the experienced portfolio managers with new managers, who quickly changed the funds to more closely follow the market index that had worked so well the past few years.  On March 10, 2000, the tech bubble began to unwind and the shareholders of those two Fidelity funds were whipsawed.  The Wall Street Journal later reported that investors lost 20% with the new manager and did not participate in the 22-23% gain they might have earned assuming the original portfolios remained in place. 

 The Bottom Line

 In the end, we agree with Malkiel that passive index investing is better than the average actively managed fund.  However, we believe you have a better chance of outperforming the market over time if you find a manager who has the discipline to stay with a proven investment approach over various market cycles. 

 The bottom line to CornerCap is that an actively managed investment discipline is absolutely critical for long term investment results.  We believe that the two biggest enemies to investing are EMOTION and FEES.  An iron-clad investment discipline—for us, ours is based on a consistent value philosophy that adheres to the principles of transparency, liquidity and reasonable cost—is the key to minimizing the impact of these destructive forces.  A blend of actively and passively managed investments to implement this discipline can serve you well.

  Past performance is no guarantee of future results.  Investments are subject to risk and any of CornerCap’s investment strategies may lose money.

 Follow this link for important disclosures and back up information.