The Great Investment Debate: Part Two
In The Great Investment Debate, Part One, Brad Swinsburg, Director of Investments outlined our preference for passive strategies, but emphasized that while performance has played a role in forming that opinion, it has not been and should not be the sole consideration. As Brad details in Part Two, our philosophy is based on a careful consideration of a number of additional passive strategy characteristics.
The Case for Passive Strategies
Tax Efficiency – Not surprisingly, given our strong belief in the integration of tax and investment planning, we view tax efficiency as a major advantage for passive strategies. This is an advantage that over the last few years has become more pronounced and visible as investors review their prior year tax returns. During the financial crisis, most active managers were able to “capture” sizeable capital losses as they sold securities to meet liquidations. Active strategies structured as mutual funds can’t distribute losses, however, so those losses were carried forward and used to offset future gains within the fund.
Given the strong recovery in the equity market since the crisis, most US-focused strategies have fully utilized those losses and are now realizing and distributing gains along with building up additional unrealized gains that increase future tax bills. That changeover started to happen a few years ago and without another significant market selloff (obviously a pain of a different type) most funds will likely be distributing capital gains going forward.
Some of these gains can be quite sizeable, come with little prior notice and occur in a year where the market is even down or flat. Those distributions occur regardless of whether the active fund holder made any trades into or out of the fund and without consideration for how long they’ve been an investor. It is certainly unpleasant to pay taxes on gains one participated in, but new investors are actually in the position of buying into realized or unrealized gains and their resulting taxes yet they did not experience or benefit from. Due to their unique ability to handle capital flows through in-kind redemptions (a far more complicated discussion for another day) passive strategies are able to typically avoid large punitive capital gain issues.
Passive investors are still subject to capital gains if or when they sell their investments, but that is something they can control and is straightforward and transparent. That leads us to the longer term tax advantages of passive strategies. As was illustrated and discussed earlier, performance between passive and active strategies can be cyclical. One could theoretically capture excess return by switching between active and passive strategies if they had perfect foresight on timing the cycles. Accurately timing such moves would of course be an unprecedented achievement, but for the taxable investors it would very likely create a tax bill that more than offsets any gain in performance. The taxable investor is forced instead to think not just about what strategy or structure fits them or the market best at a single point in time, but the one that fits best across long time periods. Remember it’s not what you make, but what you keep. After tax returns matter!
Avoiding Destructive Behaviors – Investors, amateur and professional alike, are often their own worst enemies. Chasing the “hot-dot” manager or firing a manager at the bottom of their cycle is a well understood behavior within investment management. Most assume this pattern of behavior is concentrated in do-it-yourself retail investors, but it has also been frequently observed in the institutional, professional investor ranks. While an investor in passive strategies could still chase the “hot-dot” with regard to asset allocation decisions, utilizing a passive approach on implementation removes the temptation to do so at the manager or implementation level.
Focusing on primarily a passive implementation additionally allows the advisor or investor to focus on the significantly more impactful asset allocation decisions. While an active manager may contribute or detract from the overall level of performance through outperforming or underperforming a benchmark that impact will almost always pale in comparison to the decision around asset classes and how much is allocated. One of my former colleagues used to sum it up well when he said “I’d rather have the worst manager in the best asset class, then the best manager in the worst asset class”. While most investors and advisors get this concept they still spend the majority of their time, research, and money on the manager component instead of the allocation decision. Removing that temptation has a real value in helping place the focus on what truly matters in generating differentiated returns.
Active Strategy Design Flaws – This is a bit less intuitive than the prior two arguments, but conceptually points to the difficulty faced by active managers simply due to the dynamics of the investment vehicle or business itself. As an example, most large asset management firms understand the “hot-dot” behavior mentioned above, so the fear of large asset outflows during difficult performance periods drives a culture or risk management that reduces the willingness to diverge from their benchmark or its “active share”. Active share is a measure of the holdings of a portfolio relative to its benchmark. The less the active share the more benchmark like their performance will be.
Asset management firms and managers operate under the assumption that modest periods of underperformance will not result in significant outflows and help create a steadier business. Add in the impact of the management fees on performance and it is easy to see why achieving any level of significant or meaningful outperformance is difficult to achieve and even harder to maintain over long periods. Additionally, most managers by design or simply due to normal portfolio activity also maintain some level of cash in portfolios. The impact on a daily basis may be small, but if done consistently eventually creates a drag on portfolio performance.
As stated at the outset of this piece we are biased towards passive strategies, but believe that active strategies can also play a valuable role in portfolios. We’ll never use an active strategy to implement when a passive strategy is just as likely to achieve the desired result with the same level of risk. The active strategy in a sense has a higher hurdle rate to get into a portfolio as we must believe that it offers a unique exposure that can’t be as easily or cheaply replicated via a passive approach.
What are the situations or circumstances in which we would consider employing an active strategy or manager?
- Opportunistic Strategies – as discussed, many managers end up looking a lot like their passive benchmark or index (often referred to as hugging the benchmark) for business risk purposes. We are much more inclined to utilize an active strategy when that manager has demonstrated a willingness to diverge from their benchmark and has been successful in doing so.
- Expensive Markets – as markets become more expensive and the opportunity set of attractive securities narrows an active manager (again one willing to take active risk relative to its benchmark) becomes more attractive due to its expected ability to sift through their area of expertise and select investments that they believe to still be undervalued.
- Niche Markets – the universe of passive investment options has expanded tremendously over the last decade, but in some asset classes or parts of broader markets the passive options may still be somewhat limited in scope, liquidity, or availability. In those cases an active strategy may be the only way to get exposure to an investment that we’ve identified as attractive.
- Fixed Income – most indices are market cap weighted which means as an investor the weightings of each company in your portfolio are dictated by how much equity or fixed income is outstanding. Within equities, this typically means you own more of the larger companies within a particular market, asset class, or style. Within fixed income, however, that may also mean you’d own more of the more highly indebted or leveraged companies. That is less than ideal as the more levered the lower the credit quality. A passive oriented strategy may still be appropriate, but may be more of a hybrid due to an additional layer of risk management that is employed to offset any credit concentration concerns.
- Alternative Strategies – much of what investors would consider the alternatives market is not easy to replicate or invest in through a passive strategy. What falls under the category of alternative is an extremely wide range of investments with many areas having no passive alternative or at best a poorly constructed version.
As with any ongoing debate there are valid pros and cons to each viewpoint, but in our view, the arguments for passive far exceed in both number and importance the arguments against. The great thing about our position as a conflict-free advisor to our clients is that we will never be forced to choose, but can remain open minded and always focused on what is best for our clients and their portfolios.
I would be happy to discuss our philosophy in more detail with you, or to explore with you how SHWM can work with you to help you achieve your financial goals. Please call me at 404-874-6244 or email me here.
All references in this publication referring to our average allocation or “typical portfolios” reflect those of the fully discretionary accounts of clients with moderate risk profiles. Actual client portfolios are tailored to individual client circumstances and asset allocations may vary. Any reference to returns reflect the performance of asset classes, are for illustration purposes only, and do not reflect the returns of any specific investment of Smith & Howard Wealth Management. No representation is made that any investment decisions discussed herein have been profitable in the past or will be in the future. Past performance is no guarantee of future results. A list of all recommended investments is available upon request.