Sunday, March 22, 2015

What is Better---Index Funds or Active Managers?

The active and passive investment shops always argue it out over what is better---active money managers or indexing.

I just read a paper from Vanguard that, as you would expect, makes the case for index funds:

The Case For Indexing

Put alongside the paper from Ted Theodore about there being better times to be active and better times to be passive it brings up an interesting idea:

Dig We Must

What if they are both right?  There are times when stocks are uncorrelated that a good stock picker (someone who is not just hugging an index) can add some real value.  There are also times when stocks are very correlated where it is much harder for an active manager to add value.   Given this, it is very easy for both sides to data mine and pick out the times when there way outperformed as proof that one way is better than another.

However, this argument ignores the 800 pound gorilla in the room about what happens when the market goes down?  Neither active stock pickers or passive indexes will protect investors from market declines.

The better approach could be twofold:

1. Instead of active or passive how about smart beta?  Smart beta strategies fall somewhere in between, they are passive because a computer is picking the stocks just like an index fund, but they have a semblance of being active because the portfolio manager is using some sort of formula other than simple market cap weighting to pick stocks.  The smart beta strategies out there today have all been backtested and show to beat the market.  Yes, I know that nobody has ever seen a bad backtest so time will tell whether these strategies are robust going forward.  We think they will be because we believe they benefit from a value and size effect which should persist.

2. You need a tactical overlay.  Smart beta may beat the market over time but it won't protect you when it crashes either.  A tactical overlay on top of a smart beta strategy makes smart beta smarter.

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