Part of the allure of modern portfolio theory and the academic research that has become a staple of investment theory is its theoretical certainty. In very basic terms it states that through proper diversification and a long-term investment horizon – regardless of what the markets do – investors will, on the aggregate, benefit more and do so rather predictably. Index returns across all the various assets classes – which by definition are not perfectly correlated – will be the winning approach. Keep the fees very low, then buy, hold, and rebalance over long periods of time. Essentially, beta investing (getting the market returns) will beat alpha investing (trying to beat the market). Diversified allocation is king. “Everything is better with beta!” is the cheerleading chant from the indexed crowd.
By contrast, market timing and stock picking or sophisticated options and puts and shorts have great appeal for those who would make killer trades and try to multiply their capital quickly – with a lot of luck and maybe some skill. Market timing is what comes to mind when most people think of investing in the classic gun-slinging style of wild stocks and big living. The hot stock and the quick buck make for good cocktail party chatter, and the prominent practitioners – both famous and infamous – become the subjects of books and movies.
So, yes, this is the perennial active investing versus passive investing debate. Although the debate is useful, it is increasingly dogmatic and pitched as a zero sum game. But the assumption that investors must choose one investment philosophy to the exclusion of the other is flawed. It need not be a binary choice. Both options have merit depending on the need.
In the debate, however, the data in recent decades (maybe longer) seems to favor the modern portfolio theory and “allocation is king” investors. Of course there has to be price discovery (by those who trade and seek alpha), which results in winners and losers. However, the winners tend to be fewer than expected and seemingly random. For evidence, take a look at S&P Global with the SPIVA study and the Persistence Scorecards (see us.spindices.com/resource-center/thought-leadership/research/). Depending on the year, the percentage of active mutual funds trailing the market can be as high as 80% and even 90% in some market segments. And then, on top of that, the winners tend to be temporary. Here’s a quote from the Persistence Scorecard 2017 report:
“According to the S&P Persistence Scorecard, relatively few funds can consistently stay at the top. Out of 568 domestic equity funds that were in the top quartile as of March 2015, only 1.94% managed to stay in the top quartile at the end of March 2017. Furthermore, 0.92% of the large-cap funds, 2.38% of the mid-cap funds, and 2.26% of the small-cap funds remained in the top quartile.”
That record is actually quite damning for the active mutual fund industry, which continues to prominently schlep its wares at high costs with distribution muscle as if there is not a fundamental problem. Very poor hedge fund returns in recent years only highlight the point so prominently shown in the active mutual funds. Lots of selling, sizzle and sizable fees have consequences that are not consistently rewarding to investors.
Active investing will need to take a more humble and conservative approach in the future. The mutual funds can start by lowering fees across the board, which could help the performance of their funds right off the top. Then, in a moment of truth and aged reflection, half of the industry might realize that they are actually not providing much value and choose to retire. We all can agree that it was a nice idea back in the day, but the ebb of time flows onward. Active investing is not dead. The reports of its demise are premature even though the current data on the aggregate is unfavorable. A strong market correction or even a recession may change that.
There is also a problem with index investing, modern portfolio theory and its “allocation and diversification is everything” approach. The flaw is related to its strength and theoretical certainty over long periods of time. Yes, over the long-term horizon a diversified portfolio rebalanced in a disciplined way with low fees has the highest predictability of appropriate and reasonable returns. But, like a fanciful country song might state, “long-term is kind of like forever,” and nobody is immortal. As Keynes once noted, in the long-term we are all dead. For some investors in retirement, long-term investing even with some superior returns may not be a proper fit. The investor needs risk management that is not always properly accounted for with diversification only. Although the dogmatic crowd will argue otherwise, the long-term nature of index/allocation investing can actually be problematic. It is a strength and also a liability.
The key question, therefore, before investing should not be, “What is a person’s particular philosophy of investing?” Rather, the better question is, “What is the risk tolerance and timeframe for the money in question?” An institutional portfolio in a pension or an endowment or a perpetual trust may indeed have a long-term time horizon. However, funds that would be essential for living or for sustaining a purpose that cannot weather a large downturn in the market that lasts for a decade or more may need to be placed in a tactical investment. Risk mitigation and some market timing with a disciplined ability to include cash as an asset class become important elements of management. The long-term index approach will work in the short term until, of course, it doesn’t. At that point, it is too late to start thinking about short-term risk management, tactical adjustments, and capital preservation.
At Cumberland Advisors we have conservatively managed, active fixed-income (using individual bonds) and equity (using exchange-traded funds) portfolios. Our active investing with separately managed accounts works in different ways for different purposes and risk tolerances. It is a “building blocks” approach with many portfolio styles that can be used based on the investor's need.
We also have a long-term, modern portfolio theory variant portfolio with a twist and a track record spanning more than a decade. Our Active Bonds/Passive Equities Portfolio style is appropriate for funds with a long-term time horizon. As stated in its title, the portfolio style uses actively managed fixed income, which is then coupled with passive equities in a 60% equity/40% fixed-income buy/hold/rebalance construction. Within the passive equities, we have a slight tilt to mid-cap stocks versus a straight index. For institutions and other investors who want conservative allocation and very low fees in a long-term, diversified portfolio; this investment style is a solid option with an established track record since 2003. For others who have a shorter time horizon, our more tactical portfolio styles in equity and fixed income may be best.
Michael McNiven, Ph.D.
Managing Director & Portfolio Manager
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