We find ourselves in the early evening of passive investment management approaches. Despite the portfolio drawdowns we experienced in 2022, buy and hold portfolio management continues to be the overwhelming choice of investors, their advisers, financial academics, and the Wall Street giants. This idea is hard-wired into the system. After all, its worked for forty years . . .
Passive investing does offer well-known benefits: near-perfect index tracking, lower-cost, and a friendlier after-tax result. Should we even be thinking about active management? An excellent time to consider that question.
As you might have anticipated, we take the other side — we believe that active management is critical to your financial health and, perhaps, to your financial survival. We’ve held that view for a long time. Here are a few problems with passive investment management:
[1] The next ten years are highly unlikely to be like the last ten. That proposition seems much less controversial today than it did two years ago. We simply can’t bet our financial security on the idea that the future will look like the past — that investing in stocks will continue to provide positive returns with low volatility.
[2] The mechanical implementation of passive strategies tends to create feedback loops that significantly distort valuations of a small group of very large companies. The resulting disconnect between price and value for these issues will eventually become a threat to our financial system. Portfolios need to be able to manage their exposure to such a threat.
[3] Finally, the most important point: Psychologically, individuals can’t begin to handle difficult markets, even when those markets eventually recover. Every time we run into one of those “black swan” events that seem to occur every ten years or so, the drawdown of portfolio values far exceed the pain tolerance of the average investor.
This was the case as recently as 2020, when the S&P 500 saw a top-to-bottom decline of 34% in just five weeks. Then in 2022, the Nasdaq Composite was down 36% at its low in mid-October. In the major bear market events of 2001-03 or 2007-09, the eventual drawdowns were over 50%.
That level of volatility is intolerable for normal human beings. Over many decades of managing money for individual clients, we have learned that their threshold of pain is closer to a temporary loss of 10% or 15%, not 30%, let alone 50%. Whenever investors experience that much financial pain, they often take matters into their own hands, typically liquidating stock portfolios at the worst time.
As a result, those widely-advertised multi-decade “buy-and-hold” return statistics we see all the time are seldom achieved by anyone in the real world, because most investors just can’t remain in their chairs through the volatility. As a result, investor returns are seldom the same as investment returns.
Client comfort and confidence should be the first priority of professional investment management. It seldom is. Only an active approach can make volatility and drawdown management its priority.
In the strong equity markets we saw through 2021, a typical active strategy might well have delivered somewhat lower returns that a passive one. But, in a more challenging environment, an active portfolio is likely to deliver measurably smaller losses and much less volatile return patterns. That was our experience in 2022 for example.
Lower volatility and smaller drawdowns — that combination gives the investor a chance to stay in the game. To experience the benefit of full cycle, long-term returns. We have found that active strategies can deliver long-term returns comparable to passive index investments, but not always at the same time. More important for the ultimate success of the client, the active portfolio is likely to deliver significantly higher risk-adjusted returns (measured by Sharpe or Sortino ratios), reflecting the significant reduction of downside volatility.
Those Sharpe or Sortino ratios are very relevant proxies for client comfort and tenure. They improve the likelihood that clients will actually make it to their financial finish line. Survival, we have found, is a prerequisite to success.
