Index fund managers, academics, and many institutional investors have recognized the merits of passive investing for decades. However, it wasn’t until the boom of the 1990s that indexing gained popularity among even the most skeptical groups of investors. It was during this time that retail and non-US investors, historically cool to the idea of “settling” for mere market returns, jumped on the indexing band wagon, which had long been occupied by US institutional investors. As the ’90s fade we face the challenges of a new era. Market volatility has increased. A weak global economy shows little sign of a near-term turnaround. Uncertainty surrounding the duration of the current slowdown and the outcome of the war on terrorism has caused some investors to question their appetite for equities in general.

Some active managers have seized upon this environment of uncertainty and fear to make the claim that indexing is now more dangerous. They allude to the emergence of a “stock pickers’ market” and allege that passive investors are senselessly allowing index funds to “drag them down” with the market — as if somehow the market is a separate and distinct entity from investors themselves. They also assert that active managers can provide “downside protection” for investors in this type of environment. This line of thinking ignores several important reasons why investors make passive funds a strategic and significant piece of their investment portfolios. It also promotes a false impression that active managers have, in fact, been successful in providing protection for investors in down markets.

Passive investing is a long-term strategy. Those who choose this methodology do so for strategic reasons which, over time, result in superior performance and no surprises. Relative to active mandates, management fees are lower. Portfolio turnover and associated transaction costs are lower. Passive investments also offer broad diversification and stability of exposures — comforting attributes during a period of market uncertainty.

It is a strategy that empowers investors to rise above the panic brought on by random shocks to the market, and to rest comfortably in the knowledge that they have implemented a strategic plan designed to ride out short-term volatility. For example, the big lesson investors can take from the Bear Stearns meltdown is the danger of concentrated positions and the value of diversification. The impact on your portfolio should have been negligible. If not, shame on you. To an investor, the Bear Stearns event was a business risk as opposed to a market risk. Business risks can be almost entirely diversified away. So, investors should see the collapse of even a major company as a non-event. A properly diversified portfolio bears the un-diversifiable but quantifiable risks of market, size, and distress risk, nothing more.

Many active managers claim that they can position portfolios more defensively during market downturns. This may involve a change in the portfolio composition or simply an increase in cash reserves. If we believe that active managers can provide protection in these ways, the following assumptions should hold:
• Active managers can and do successfully predict bear and bull markets.
• Active managers increase cash reserves or re-align portfolio holdings accordingly.
• Active managers make better stock picking or cash-allocation decisions in down markets than in up markets.
• Protection in down markets compensates for underperformance in up markets.
If one believes that active managers struggle to beat rising markets, why then do investors believe those same managers can find more success in falling markets? The empirical evidence offers no proof that such skill exists. Regardless of the manager universe, the definition of “down market,” or the timeframe used, the results are the same. There is nothing to suggest that investors would be better off in active strategies during declining markets.

If you are looking for a long term strategy that you can depend on, contact Odyssey Advisors. Leave your investment strategy to us.

Odyssey Equity returns are calculated on a Total Return Basis and are presented net of all fees. Past performance is no guarantee of future results. The investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Performance changes over time and currently may be lower or higher than the performance data quoted above.

Mark Collard authored the above article.

Mark Collard is a Partner in the investment management firm, Odyssey Advisors, LLC. Collard received a BS in Business Finance and Accounting, Cum Laude from Saint Vincent College and an Executive MBA from the State University of New York at Buffalo.