Bull Market Revives Active vs. Passive Debate

If the bull market is running, the active management versus passive investing debate must be revving up.

The current run up in equities is indeed producing passionate arguments for both approaches, with advisors, managers and commentators from across the financial spectrum weighing in.

Advocates for passive investing point to the money that investors could have saved by investing in low-cost index funds that outperform actively managed funds of publicly traded securities. Active management proponents counter that while bull market highs make index funds look attractive this is the time when smart active managers can take advantage of market sentiment and buy the undervalued stocks that will shine when the broad market index declines.

Burton Malkiel, who wrote the investment classic “A Random Walk Down Wall Street” and is chief investment officer of Wealthfront, elevated the controversy on Wednesday when he charged in a Wall Street Journal opinion piece that “the high fees charged for active management cannot be justified.”

Advisors and wealth managers who use active strategies strongly disagree, however.

“Fees can be justified because you want someone with the ability to navigate turbulent markets,” said Robert Luna, CEO and chief investment officer for Phoenix-based SureVest Capital Management. “I think active management and financial advice go hand-in-hand because you want to correlate an investment portfolio with the financial profile of the client. An index fund has no idea who the investor is, if he or she is 7 or 70, and investment decisions aren’t going to be made in conjunction with that individual’s needs at a particular stage in life.”

Malkiel’s contention that “outperforming the consensus of hundreds of thousands of professionals at the world’s major financial institutions is next to impossible” was challenged by Kevin Bernzott, chairman and chief executive of Camarillo, Calif. Bernzott Capital Advisors.

“There are a number of active managers who significantly outperformed their relevant benchmarks over long periods of time,” said Bernzott, who is writing a white paper titled “Active Management Is Not Dead.” He cited his own small cap value strategy fund, which, he said, has beaten the Russell 2000 Value Index by 315 basis points on an annualized basis for nearly two decades.

Both Luna and Bernzot acknowledge that some of Malkiel’s arguments for the merits of passive strategies are valid.

“There are a boatload of active managers who are not adding value,” said Bernzot, whose fee for retail clients is 95 basis points as a percentage of assets under management. And index funds and exchange-traded funds do provide investors with meaningful returns at a low cost during bull markets, admitted Luna, whose fees start at 1.6% of AUM and are reduced to 1% as assets are increased.

But Luna cited the famous Quantitative Analysis of Investor Behavior study by the Dalbar research firm showing that individual investors tend to buy mutual funds during bull markets when the price is high and sell when markets dip and prices are lower.

“There is an active component to ‘passive’ investments like index funds and exchange-traded funds,” he noted. “You have to make an active decision when to buy and when to sell. And individual investors who are not professionals tend to make emotional decisions that they are often not able to recover from.”

Active managers, Luna argued, can identify stocks that have become over-valued in a bull market and reduce those positions. Conversely, he said, they can also buy stocks that have underperformed and overweight those positions to take advantage of price run-ups when other sectors decline.

As Dan Weiner, chairman and chief executive of Adviser Investments, puts it, “the value of a good active manager is that they aren’t forced to load up on the biggest, best performing stocks which cap-weighted indexes do by default. They can tilt against the wind and the best of them do precisely that.”

Advisors who are considering working with active managers should make sure they are in compliance with the CFA Institute’s Global Investment Performance Standards and are independently audited by a third party, Bernzot said.

“Then you can really compare apples to apples and not just ‘trust me’ promises,” he said.

And the longer an active manager has been in business the better, Bernzot added. “You don’t want to invest in a strategy that’s unproven.”