Active versus Passive Investing
This topic was very popular in the mid-to-late 1990's in the media and has always been popular in the academic world. In 1994, the S&P 500 Index, a widely recognized standard for measuring the performance of large-cap stocks, began to outperform the majority of mutual funds, especially versus styles where market capitalizations were much smaller.
Index investing became very popular and the Vanguard Group greatly benefited from these market trends. At the time, Vanguard was known largely for its index products and its low expenses. Vanguard also had many actively managed funds with excellent track records.
As a research associate for Lipper Analytical, one of my responsibilities was providing statistical reports and information to the media. The media frequently requested reports concerning active versus passive management. These reports generally showed that the S&P 500 Index outperformed the overwhelming majority of mutual funds from 1994 through 1998. This is not to say active managers were not making money for shareholders. On the contrary, most investors made a significant amount of money over that time period. At the same time, however, some of those same people were very unhappy because their investments were not returning as much as the S&P 500.
The S&P 500's performance greatly impacted the way managers positioned funds and how marketing departments pitched products. Marketing and sales departments had a difficult time selling products with performance that trailed the S&P 500 by a wide margin. As a result, some managers were pressured to align funds much more closely with the index.
Some GARP or growth at a reasonable price managers became closet indexers while some value-oriented managers became GARP managers. These strategy shifts helped to make products perform more like the S&P, but they rarely outperformed the S&P 500. In 1998, the peak of the large-cap bull market, the S&P 500 was outperforming at least 80% of the domestic stock funds universe. For the five years ending in 1998, that percentage was probably higher.
The bottom line is that many companies and managers were willing to accept returns that fell short of the benchmark in exchange for a better opportunity to sell products. This strategy of course backfired, as large cap stocks started to underperform other investment styles.
The strategy of aligning your portfolio to more closely resemble the S&P 500 achieved its purpose but at a steep cost. Funds that changed their strategies reduced performance deviation from the index, but also significantly increased the probability of underperforming the index.
So how does an investor outperform the S&P 500? The answer starts with investing in funds that are materially different from the S&P 500. Sure, there will be years when you lag behind the pack. But, you should also have a higher probability of outperforming the S&P 500 when large cap stocks are not in favor.
The indexing strategy is most effective in the large-cap universe. The S&P 500 outperforms most large-cap funds over long periods of time. In this universe, companies are widely followed and information travels quickly and freely. It is very difficult to gain an advantage over your competitors by having better information. This is especially true in the post World Com and Enron era. Indexing is much less effective in the small-cap area. Here, managers can much more easily add value through security selection.
Overall, index strategies are reasonable approaches if you do not have the time or experience to find high quality mutual funds or if you limit the indexing strategy to areas of the market where managers have difficulty adding value.