Back to Basics

Happy Memorial Day!

And welcome to the first official newsletter of ATI Wealth Partners!  Don’t worry, it’s the same semi-sensical content you’re used to seeing, just in a different wrapper.  Or really, the exact same wrapper, just with a different name.  Which, coincidentally enough, is a brilliant segue into this week’s topic: the resurgence of active management.

Quick primer:  If you just “buy the market” with an index fund, that is considered passive management.  Your returns are going to be whatever the market returns (minus the expense ratio on the fund).  Active management tends to mean stock picking - trying to put together a portfolio of companies that will outperform the broad market based on whatever metrics they think are adequate predictors of performance (RIP Paul the Octopus).

Passive investing has become increasingly popular over the last two decades thanks to the increased prevalence of ETFs (exchange-traded funds) and index mutual funds.  Money flowing into these passive products means money is notflowing into (and has been, in fact, flowing away from) active managers.

So active managers are understandably freaking out and trying to fight back by both extolling the benefits of active management and taking shots at the popularity of passive index funds.  See any of these articles for a taste of what we mean: Forbes, Barron’s, Morgan Stanley, CNBC, or this particular gem from an active manager comparing passive investments to the Dutch Tulip Bulb Mania of 1636.  The arguments tend to be some combination of the below, to one degree or another:

• Volatility has been historically low, so it will be easier for active managers to beat the market as volatility normalizes
• It’s easy for passive funds to look good when the market is going up, but active managers will protect your portfolio when the market drops
• Everybody who is investing in passive funds now will all try and sell at the same time when they want to get out, thereby reducing liquidity and exacerbating the decline in those funds

If you have been with us for any length of time, you have probably heard one or two comments from us about our views on “buy and hold” investing.  If you haven’t, go ahead and refresh your memory a bit.  For those tl;dr out there - we don’t like it.  (Caveat: We don’t like it given current market levels. If we expected 12% returns from the market over the next 10 years, then sure, buy whatever you want and sit on it.  But at 8 years and counting into this bull market, we don’t think it’s the best advice to just close your eyes for a decade and hope your money is going to work hard enough for you.)

That, however, categorically does not mean we are on board with active management vis a vis picking individual stocks.  Most of the arguments active managers try to present against ETFs display a patent misunderstanding of how those products work.  We’re not going to dive into that here, but give us a call if you have any questions or feel like your friendly neighborhood insurance broker is getting pushy.  The argument about active management protecting on the downside or outperforming the broad market does hold water, but can be 1) hard to find and 2) even harder to sustain year over year.

You know that S&P 500 index we reference a lot?  The “S&P” stands for “Standard and Poor’s”, and they’re a company that puts together a lot of different indices and also does some cool market research.  One of those research pieces looks at how active managers have fared against the index they are trying to beat.  Last year, the S&P 500 index did better than 66% of the managers who were trying to beat it.  So yes, some active managers outperformed like they were supposed to, but most did not.  Over longer time periods, the numbers actually get worse for active managers.  The index beat 93% of active managers over three years, 88% over five years, 85% over 10 years, and 92% over 15 years.

Another fun research piece they put out looks at the persistence of outperformance by those active managers.  Let’s say you managed to pick one of the active managers in the top-25% of performance back in 2014 (side note - they probably still didn’t outperform the S&P 500 that year...).  What do you think the chances are that your active manager is still in the top-25% of active managers at the end of 2015? About 1 in 5.  And at the end of 2016? About 1 in 50.  (You can find the data here and poke around for yourself if so inclined).

One final note on the data - 2008 was the worst year for the S&P 500 since Herbert Hoover was President...yet less than 50% of active managers were able to beat it that year.  Starts slow clap.  Well done on that downside protection thing, guys.

So if we don’t like stock-picking and we don’t like buy-and-hold, what do we like?

We’d call it active management of passive investments.  We believe that index strategies are a more efficient way to capture return in the long-term, but we understand that future returns are dependent upon current valuations.  We believe active management can help limit losses in a down market, but not by picking “better” stocks that don’t lose as much; rather, we feel losses are best limited by simply not being invested when the market is falling.

There’s a chart that gets trotted out by buy-and-hold proponents showing what your market returns look like if you miss the best X number of trading days in a year...ever seen something like this?

And then there’s usually some platitude about how market timing is impossible and you’re better off just staying in the markets because nobody can avoid all the worst days while capturing all the best days.  Fair enough, but that’s only half the story.  What if you missed the best AND worst days in the market?  (Because, say, your active management of passive investments strategy had you less invested…).  Here’s a chart that looks at quarterly periods over the last 66 years:

And on a different time scale, here are the numbers from last year:

• 2016 S&P Return:  9.6%
• Missing the 10 worst days: 36.2%
• Missing the 10 best days: -9.8%
• Missing the 10 best AND 10 worst: 12.1%

Source: My Saturday morning and Google finance.

What’s the lesson to be learned here?  Losses are terrible for a portfolio.  And minimizing them is desirable, even if that avoidance comes at the expense of missing some of the best trading days of the year.

So.  A rather numbers-heavy note this week, but just think of it as brain training for the summer.  In a nutshell this is our strategy - active management of passive index funds.  If that sounds like something that makes sense to you, why not give us a call?  We’d love to discuss a downside protection strategy for your portfolio, wherever it’s held.

Now go enjoy those barbecues and other Memorial Day festivities and we’ll be back on the other side of the (spoiler alert!) DOL Fiduciary Rule implementation coming June 9th!