Implementing Your Asset Allocation: Active Management or Indexing?

Once you've determined the asset allocation that is best for you, you have to implement it via the investments you choose for your portfolio. At this point, the most important question you have to answer is whether you are going to take an active or a passive approach to investing. In a nutshell, the active investor believes that he or she can regularly generate (or choose fund managers who can generate) returns that are above the returns generated by some benchmark portfolio. In contrast, the passive (or index) investor wants only to match those benchmark returns at the lowest possible cost. Of course the skeptical reader can already see the potential for "gaming the system" here, via one's choice of a benchmark. So, let's make things simple and say for example that the benchmark is a mix of U.S. equities (60% Russell 3000 Index) and U.S. bonds (40% Lehman Brothers Aggregate Index).

Let's further assume that "Cousin Charlie" offers to manage your money for you (for the "bargain" fee of only 2.5% of your portfolio's value per year). He says he can invest it in U.S. equities and bonds and generate returns above your 60/40 benchmark while taking on no more risk than you would if you simply divided your portfolio between two no-load index funds (which, incidentally, would charge you only one half of one percent (.5%) -- or less -- of assets per year). Which one should you choose?

First, let's look at the difference in cost. Over time, that extra 2% per year you are paying to Charlie really adds up. Let's assume an initial portfolio value of $100,000. Let's further assume that, contrary to his expectations, Charlie actually earns returns that are no better or no worse than the index fund returns. How much worse off will you be in the future because of the extra 2% you paid to Charlie? Due to compounding (that is, due to not only the extra 2% you pay this year, but the extra returns you could earn on this in every subsequent year), your "Charlie" portfolio will be worth $21,899 less than your index portfolio after ten years, and $64,061 less after 25 years. This quickly gets us to our first conclusion: if you are going to place your portfolio with Charlie or any other active manager, you should be very sure that they have what it takes to deliver returns that are above the returns that you could earn on a portfolio invested in index funds. How much above? The additional active management returns over the time period during which the portfolio will be invested have to at least equal the cost difference between active management and index (or passive) investing in order for you to just break even, and they have to exceed them for you to come out ahead.

Second, let's not forget about taxes. Is Charlie promising to earn after-tax returns that are higher than those you could earn on the index funds, or is he talking about pre-tax returns? If he is like many active managers, he's talking about the latter. And this is a critical distinction. Why? Because most active managers trade far more often than index funds do. Technically, this is known as having "higher turnover" in their portfolio. Practically, higher turnover means that at the end of the year, Charlie will have realized more short and long term capital gains, which means you will end up paying a higher tax bill than you would if you had invested in the index funds. So in order for Charlie's offer to be the better deal, not only do his active management returns have to exceed the difference in direct costs between his offer and the index funds, but they also have to exceed the difference in tax effects.

Third, let's ask how Charlie might be able to "beat the 60% equity/40% bonds market index" we have defined as our benchmark.

What might Charlie do to earn more that that additional 2% he's charging you? Broadly, there are three ways Charlie could earn returns above the 60/40 benchmark you have set for him: (1) he could anticipate changes in the returns to equities and bonds and adroitly shift the portfolio's asset class weighting to anticipate them (this is known as market timing); (2) he could over or underweight different sub-groups within an asset class - for example, investing more than the benchmark in small cap growth stocks and long term bonds (these are known as "style tilts"); and/or (3) he could do a superior job of security selection - investing, for example, 50% of your assets in the stocks of just thee companies whose value he expects to increase by a lot very soon (also known as "stock picking").

So far, so good. We understand what Charlie could do to earn returns above our 60/40 benchmark, while taking on no more risk. The more interesting question, however, is just how Charlie will know when, and to what extent, to make these active moves, or departures from your basic 60% equity, 40% bonds asset allocation strategy.

Basically, the insight behind Charlie's active investment management decisions has to come from one of two sources. Charlie must have either information that isn't available to everyone else in the market, or he must have a superior model for generating insight from information that everyone else has access to.

With respect to superior information, we don't mean "inside information" that is illegal to trade on. Rather, it is a well established fact that new information doesn't diffuse instantaneously to all investors. It takes time to reach some people, and, if Charlie can act before they get it, he can make money on the trade.

With respect to a superior model, you hear about them all the time, whether it is in the form of a manager who takes a "fundamental" approach and has "superior insight" into the meaning of industry trends, or a better "earnings forecasting model", or one that takes a "technical" approach and who as a result has a "great feel for the market" and an ability to anticipate other investors' next moves and trade ahead of them to make money. Finally, both of these approaches also assume that the investment manager in question is superior to the thousands of other highly trained and intensely competitive people who are also pursuing the prize of above benchmark performance.

Of course there's also a third reason Charlie might generate returns that are better than the benchmark he's measured against: he just might get lucky. The real problem is that over short periods of time, it is statistically impossible to distinguish between good luck and superior investment management skill. The only way to do this is to measure a manager's results over a long period of time, as only consistent returns above the benchmark can conclusively prove the presence of skill.

Now we get to the crux of the problem: If Charlie is like most managers, he probably doesn't have a long track record of performance in up and down markets that you can use to judge his skill. So what can you do? To start with, you can try to look at Charlie in a broader context.

Unfortunately, that broader context isn't a pretty one for Charlie and most other active investment managers. To begin with, the gains and losses of all active managers must balance out (before their fees) to equal the performance of the market index. So it's guaranteed that at least some active managers will fail to beat the benchmark in any given year. And if superior performance is concentrated in only a few truly superior investment mangers, most everyone else will, by definition, fall short of the benchmark's performance. This is pretty much what seems to happen.

While different studies cover different periods and different managers, virtually all of them find that a majority of active managers usually fail to beat their benchmarks in any given year. This percentage only grows as the performance measurement period increases (e.g., to five, ten, and twenty years). It is easy to understand why this is so. Think of any professional sport, where the best athlete's in the world compete against each other. How many players, or teams, come out on top year after year? Not many. In fact, so few are able to do this that we hold them up as legends or heroes. When you are competing against the best players in the world, coming out on top in one year is possible; doing it consistently over a ten or twenty-year period is next to impossible.  It is easy to see why this happens in investment management: superior sources of information dry up, and/or superior models are either copied by competitors or invalidated by changes in the economy (or the behavior of other investors) that undermine their assumptions.

We know what you're thinking at this point. "All I need to do is invest in funds whose managers have done well over the past five years." Unfortunately, there has yet to be an academic study that shows good mutual fund performance persisting over successive multi-year periods. In other words, investing in a fund because it had great performance relative to other funds over the past five years does not increase your chances of having a fund that will deliver great relative performance over the next five years. In fact, many studies seem to show that it does just the opposite. The truth of the matter is this: it is no easier to pick a manager who will consistently deliver better than index fund returns than it is to be one of those managers.  In hindsight, we can point to Warren Buffett today and say that he is a truly skilled manager. However, hindsight isn't the same as foresight. If it was, there would be a lot more people who could say they spotted Buffett's talents early, and invested in Berkshire Hathaway in 1970. If you don't believe this, ask yourself two questions: Which investment manager today is the next Warren Buffett? And how much of my wealth am I willing to entrust to his or her skills?

Finally, there is the more recent phenomenon of successful investment managers leaving mutual funds (which normal investors can access) and moving to or starting their own hedge funds (which only the richest investors have access to) because hedge funds pay good investment managers much more than mutual funds. This means that if you find a good fund manager who you think has the potential to deliver above benchmark returns over the next twenty years, the odds are very high that he or she will soon be leaving for a better paying job with a private fund you can't invest in.

When you add up all these arguments, it should come as no surprise that a lot of people have chosen to use index funds rather than active managers to implement their asset allocation strategy. Much more information about the indexing versus active management argument is available in our book, Indexing Versus Active Management and in The Index Investor, our monthly journal.

Another issue on many investors minds is what exactly are you paying for, beta returns and/or alpha returns. The separation of beta and alpha is discussed in our section Separating Alpha From Beta: Portable Alpha.

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