A Passive Approach to Stock Investing

Active vs Passive Investing


Let Data Drive Decisions

Passive versus active…the debate that has been around for a number of decades continues. Can investors find equity managers who can consistently outperform their respective benchmark index? Or is the effort to pick active managers a wild goose chase that ultimately leads to disappointment? Shouldn’t investors just focus on solutions that will consistently track the benchmarks, which are typically much lower in cost and much more tax efficient? At Hewins Financial, our equity portfolios are heavily weighted towards passive solutions and over the years that tilt has become even more pronounced. Why? As an independent advisor that only earns fees from our clients rather than compensation from fund managers, we let the data do the talking, and we interpret the data to be speaking very loudly and clearly these days.

Every six months Standard and Poor’s issues a report on how fund managers are performing relative to their benchmarks. The most recent report was published this past September, and the latest results are just devastating for the active managers. For the last three years ended June 30, 2012, 85% of domestic large company stock funds trailed the S&P 500.1 The numbers are similar in mid-cap (86% trailing) and small-cap (84%).2

Why the severe underperformance? We can speculate that perhaps active managers have been fearful of repeating a 2008 collapse and have positioned themselves too defensively, or that their ability to predict has worsened in this environment of unprecedented monetary and fiscal policies, both in the United States and around the world. But aren’t these kinds of great challenges exactly why we are supposed to pay the premium for active management? Shouldn’t this be the exact time that active management flourishes? The data seems to make the opposite case.

Recently we implemented a change in our model portfolios. One of the few areas in the equity space where we continued to hold an active solution was in small cap growth. The traditional argument for active management in this area has been that the fund manager has a large number of small companies to consider for investment and that the manager’s expertise in evaluating businesses in growth sectors like technology and consumer services should easily be able to beat an index of small growth stocks. The active small cap growth fund we had been using had been underperforming and recently announced a change in management. Our investment policy committee voted to make a change.  In our evaluation of the small cap growth universe of funds, it became apparent that even in this space we believed that a passive choice was superior, especially in consideration of the longer-term performance, lower cost and tax efficiency. The committee voted to implement the Vanguard Small Cap Growth Index Fund as the replacement. Based on the S&P report, a stunning 93% of small cap growth funds underperformed the S&P small growth benchmark over the last three years.3

Our data-driven approach is just that, and we are committed to not let our concentration in passive equity solutions turn into dogmatic policy. Our approach in fixed income, for example, is quite different…but that is a topic for another time. The point is that our portfolio construction is based on objective, well-reasoned thinking that is free from underlying financial arrangements with the money management industry. If the data suggests that active equity management is not living up to its promise, which we believe has been the case in recent years, we act accordingly.

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A Passive Approach to Stock Investing

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