Active or Passive? Try (Parts of) Both

Should you choose actively managed funds for your investments, or passively managed funds? It’s one of the investing world’s great debates. And in a new research paper, James O’Shaughnessy’s firm says the answer is, perhaps you should use a little of both.

Passive funds, Patrick O’Shaughnessy writes in the report, have three key advantages over active funds: lower fees, reliable strategy, and in some cases better tax management. But, he adds, they have a huge weakness that trumps those advantages: “the inferior strategy used by most indices to select and weight stocks.” Most passive funds weight stocks based on market capitalization; the bigger the stock, the more you own of it. “But the long-term evidence makes it very clear that buying a stock — or holding more of a stock — just because of its market cap is a losing strategy,” O’Shaughnessy writes. As an example, he shows how, since 1963, the company with the highest market cap in each of the market’s 10 sectors has on average returned 8.54% annualized, lagging the S&P 500 by 1.3% per year. The best value in each sector (determined by using OSAM’s “value composite”), meanwhile, has averaged annualized returns of 14.6%. Those figures include much lower average passive fund fees for the market leaders and higher fees for the bargains, showing that “‘the tyranny of compounding costs’ cannot come close to diminishing the power of value investing.”

But O’Shaughnessy also says that investors are wise to include elements of passive investing in their approach, and use a strategy that “emphasizes discipline, a consistent strategy, and a long-term focus.” He looks at some examples of strategies that embody those qualities, but which don’t use market cap as their selection criterion. The top performer, the “Concentrated Value 50”, looks at the largest 500 U.S. stocks, ranks them by their valuations using OSAM’s “value composite”, and then chooses the top 50 bargains and equally weights them in an annually rebalanced portfolio. From 1963-2012, this portfolio returned 13.62% annualized (net), while a market cap weighted portfolio of the 500 largest stocks returned less than 9% annualized (net). That includes passive-level fees for the cap-weighted portfolio, and active-level fees for the Concentrated Value 50.

O’Shaughnessy says that when using these types of strategies, “discipline is as important as the investment strategy itself. Even though the Concentrated Value 50 strategy is very successful in the long term, it still loses to the Market Cap Weighted 500 strategy in roughly 25 percent of rolling 3-year periods. As we have experienced during periods of real time underperformance for the strategies that we manage at OSAM, it is difficult to stick to a strategy when it is doing poorly, but we do not waver. A disciplined approach is difficult mainly because as human beings, we cannot help but extrapolate short-term trends too far into the future. This often causes us to abandon strategy at the worst possible time.”

O’Shaughnessy says many active funds are “closet indexers” — that is, their holdings are very similar to the index against which they are benchmarked, leading them to generate similar gross returns as their benchmark, which then fall below the benchmark when fees are tacked on. He says investors should thus look for funds whose holdings tend to differ from an index.