By Raymond T Bridges CPA, Bridges Capital LLC

With numerous studies demonstrating that passive index investing consistently outperforms most active managers over the long term, one may question why investors would opt for an active manager. It might be more advantageous for investors to simply purchase a low-cost passive index, like the S&P 500, and passively accumulate wealth. This perspective not only challenges active managers but questions the entire investment services profession in its current state. Perhaps this shift is one reason why large investment management firms are transitioning from emphasizing investment returns to adopting more of a life planning service model to justify fees. However, fortunately for active managers, when comparing theoretical models to real-life situations, externalities often come into play.

Externalities, an economic term denoting the unseen costs or benefits of actions, are significant factors. For investors with a suitable risk appetite and a long time horizon, say 20-40 years before needing to make withdrawals, passive index investing through qualified plans is often the most mathematically sound option. However, the majority of wealth in the country does not belong to individuals with 20-40 years to spare before making withdrawals. Most wealth is held by those either currently withdrawing or preparing to withdraw from their savings to supplement their lifestyle. For these investors, surpassing a 100% equity invested allocation portfolio may not be the primary goal. Instead, they aim to see their account balance maintain its value during withdrawals, grow to keep pace with inflation, and enhance their lifestyle over time.

Maintaining the account value while making withdrawals and outpacing inflation to improve one’s lifestyle is a commendable goal. With over 20 years of providing financial management services to clients, this goal has been found to be prevalent among most investors. Consider an investor with a $1,000,000 savings, withdrawing $10,000 monthly to supplement their income. On a typical year, the investor is withdrawing 12% of their portfolio. A successful active manager should be able to sustain the account value close to highs with occasional outsized returns, allowing the account to grow and keep pace with inflation. In contrast, a passive index strategy will not consistently maintain the account balance. The 5-year standard deviation of the S&P 500 is approximately 19%, and in certain years, such as 2020, the index was down around 40%. This volatility not only concerns typical investors needing their savings for their current lifestyle but also compels them to take a larger percentage of their lower account value to maintain their lifestyle. Withdrawing a larger percentage during periods of volatility forces the overall return to recover much faster than a similar account unaffected by the same level of volatility.

Studies illustrating passive investing outperforming most active managers typically focus on absolute returns over time. They do not delve into specific account-level returns, where investors make distributions to support their lifestyle. Nor do they account for the emotional toll volatility takes on investors. Many investors relying on income from their savings have been known to sell at the worst possible time due to the fear that recovery is beyond reach, negatively impacting their lifestyle as their account value suffers from volatility. This action ensures the account will not recover and further detrimentally affects the passive investor. This is why most investment managers find themselves in one of two categories: the active manager aiming to smooth out account volatility or the relationship manager acting as a counselor to prevent investors from selling out when emotions take over.

Successfully managed Active Exchange Traded Funds (Active ETFs) can play a unique role for both investors and investment managers. These Active ETFs can serve as a long-term hold for the account, utilizing the tax efficiency inherent in ETFs by not passing out taxable capital gains in the year of the rebalancing trade. A well-managed Active ETF can mitigate volatility, achieving the goal of maintaining account value and growing to outpace inflation and enhance lifestyle while the investor takes regular distributions to supplement their lifestyle. Investors can identify these successfully managed Active ETFs by examining the Sharpe Ratio or Sortino Ratio of the ETF and comparing it to the ratio of the index. Investing isn’t always about absolute returns; a successful measurement of “beating the index” should consider a risk-adjusted return.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Original: Investing Feed: Active vs Passive Management, A Perspective