Active vs. passive: Is it for real?

By Jerry Wagner

The active management versus passive management debate has been going on for years. But one aspect that doesn’t always get enough attention is investor behavior.

I was reading an article in Proactive Advisor Magazine by a behavioral finance professor that made several interesting arguments in favor of actively managed accounts. While I invite you to read the entire article, I’d like to focus on his thoughts about the instrument most often associated with passive investing: the index fund.

Index funds are not made for investor mindsets

I think most of his behavioral arguments go back to a simple principle that he stated at the beginning of the article: “Even investors with the right intentions stray from a strict adherence to an index fund, thereby negating its hypothetical long-term benefit.”

This is a function of human behavior. As I have often pointed out, S&P 500 Index funds are not made for investor mindsets. Most investors will not sit still in an investment that loses more than 50%.

And if they do stay in and it returns to breakeven, they are more likely to sell when that happens than to hold on. But let’s say they do hold on at the urging of their advisers. Will they do it if the market takes another major tumble?

That’s essentially what happened to investors in the S&P 500 Index, and the funds and ETFs that track it, in the decade from 2000 to 2010. In this sense, it’s also easier to understand why some investors who abandoned stocks in the first decade of the millennium failed to return.

And that’s why the professor contends that the results cited for the S&P 500 may not reflect actual investor experiences. While investors could have earned great returns over the very long term, many would not have. Human behavior would have caused them to abandon the investment long before the long-term gains were achieved.

Market actions can cause investors’ behavioral tendencies to take over, leading to management decisions that run counter to their best interests. They may end up selling low and buying high.

“Buy and hope” isn’t practical advice

Advocates of index funds often tell advisers that it is their job to convince their clients to “buy and hope”—to hold on no matter what the markets do. And it is good advice. It’s just not always practical advice.

Most people have learned that if you’re standing on the railroad tracks, it’s best to get off them when a train is coming. That’s learned behavior, and it’s hard to ignore it when it comes to investing—when your starting investment of $100,000 has fallen to $45,000 in an S&P 500 index fund or $25,000 in the NASDAQ variety.

Think about how hard it is to unlearn the behavior that results in smoking or overeating. When you diet, do you unlearn the behavior? Or does your weight start to creep up on you? Some people are successful at these tasks, no doubt, but most people have great difficulty unlearning behavior.

And don’t forget, advisers are human too. They have been stopping at red traffic lights their whole lives. They don’t plow through just because someone says the road is clear.

Some of the growth of passive funds is from active managers

A chief reason people say passive investing won the debate in the years following the financial crisis is that passive funds and ETFs grew in assets while active funds lost them.

Importantly, this argument ignores the fact that passive funds are the vehicles used by active money managers. It’s difficult to separate the active buying from a true passive investor’s buying.

An active adviser can buy and sell index funds to pursue returns better suited to their clients’ risk profile. Some do this by investing in a number of passive indexes and hoping diversification and occasional tweaking will protect their clients, even though this approach has not always provided sufficient protection during major market downturns.

Advisers can also use passive index funds to dynamically manage portfolio risk. They adjust portfolio risk to help overcome human behavioral tendencies. Flexible Plan Investments has done this for 45 years, using systematic, computerized trading plans designed to reduce the influence of subjective decision-making while providing the discipline to stay on a risk-management “diet.”

As the professor concludes, “Risk tolerance and the desire for control are not constants among the investing populace, and behavioral studies also show that they vary with age, wealth, and life circumstances, not to mention the market environment. Many investors need tailored, flexible strategies that can dial the risk level up or down according to the variables mentioned [in the article], getting more defensive or aggressive as conditions warrant. In most cases, active managers can supply these strategies better than the individuals themselves.”