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Active and Passive Investing

During the past several years, you have probably seen numerous articles in the financial press about active versus passive investing. You even may have seen headlines pronouncing the death of active management. During the same several years, money has been flowing out of active and into passive funds. Does this mass exodus from active to passive indicate that passive investing is fundamentally better? Are those of us who continue to believe in active management missing the metaphorical boat? Our answer to both questions is a resounding “no.” We believe the right kind of active management not only works well but is also a necessary complement to your passive holdings.

Let's define what we mean by active and passive. Simply stated, an active investor is trying to outperform an index (for example, the S&P 500); whereas, a passive investor attempts to match the index returns by replicating the investment weightings of the index. Both strategies have inherent benefits and shortcomings: passive investments (index funds and ETFs) have lower fees but offer no cushion against the risk of losses during downward market movements; active funds generally have higher expense ratios than index funds, but they also may take actions to minimize losses during market downturns while offering the potential to outpace the market over the long term.

Where the Index Goes, the Index Fund Follows
Passive investments have been around for over 30 years, so what changed to make them so popular? As we've seen from 2009 to the present, index fund returns are great during extended periods of steadily rising stock prices. As the saying goes, “A rising tide lifts all boats.” At the same time, many active managers have been unable to keep pace. Things like cash holdings, fees and a lack of investment opportunities (underpriced stocks) can impede active managers in an aggressively rising market. But history shows that the market won›t go up forever—and we are currently in one of the longest bull markets in history.

Today many research professionals believe we are in the late stages of a bubble in passive investing. A bubble is a market phenomenon that occurs when certain investments have been valued—regardless of fundamentals—to prices that are far too high compared to their intrinsic value. Inflated prices cannot be sustained in the long run, and the bubble eventually deflates. Most recently, we saw this happen with the dot-com bubble in 2000 and the housing bubble in 2008. Another possible outcome is that the market goes sideways as company valuations grow into their prices. And we know wherever the index goes, the index fund follows. So, how can passive investors reduce damage to their portfolios during a sideways or negative market?

Why Should I Pay for Active Management?
When you hire an investment professional to manage money on your behalf, you are essentially paying them to provide the things passive investments can't; namely, the flexibility to make decisions based on in-depth company and market research. (Remember, passive investing ignores the fundamentals of individual companies.) During periods of volatility, you are also paying active managers to employ strategies that may offer some level of protection against losses. Outperformance in the long run can require not only outpacing the market during upturns but also losing less than the market during downturns.

Of course, no active manager can produce above average returns across all time periods, but there are many who have outperformed over the long term. If you decide to hire a portfolio manager, it makes sense to choose one who has years of experience managing assets through various market cycles. History and research also show that managers who consistently beat the market over time have the following qualities:

  • Invest in their own funds alongside their clients
  • Portfolios with low turnover
  • Focus on fundamental business values
  • Long-term investment horizon
  • Reasonable fees

Is Value Investing a Good Option?
According to a January 19, 2017, Financial Times article, going forward “The only way for active investors to outperform is to discover and exploit pricing errors by other expert professionals… .”

Lest this sound suspiciously like value investing, that›s because it is. Value managers don›t simply buy the market. Value investing is based on the fundamental notion that, in the short term, human behavior and stock prices will always be more volatile than actual changes in fundamental business values. Price and value are not only different, it is precisely that they can differ widely that creates the opportunities for active investors to earn excess returns. The value investor›s job is to take advantage of this difference between price and value. The greater the difference, the greater the potential return.

Active AND Passive
Index funds can certainly be part of a sensible investment strategy for those who understand their virtues and limitations. Even Warren Buffett, one of the greatest active managers of all time, has endorsed the S&P 500 index fund as a good alternative for those investors not willing or able to select securities or fund managers on their own. (Of course, Buffett's suggestion assumes a buy-and-hold strategy. Passive investing only works if the investor is truly passive.)

At Weitz, we believe there is a case to be made for active management, and we intend to continue to do our best to add value to our clients' long-term returns. As long as human behavior doesn't change (and chances are it won't), there will always be opportunities for value investors to outpace the market over time.

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