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The issue of active vs. passive investing typically centers on the nature of the actual investment product: “Is it an actively managed fund or a passive index fund?” However, this is only one aspect of the active vs. passive debate, and presents far too simplistic a view. There is a broader, macro issue that applies to the broad portfolio; namely, “How is the portfolio of actively managed funds or index funds managed over time?”
For example, if there is a large amount of turnover in a portfolio of index funds, it is an actively managed portfolio of passive index funds. Very simply, it is an “active-passive” portfolio. By contrast, an investor who purchases index funds using a buy-and-hold approach has a “passive-passive” portfolio. In short, it is possible to be an active manager of passive funds, or a passive manager of actively managed funds.
In sum, the terms “active” and “passive” can apply to the nature of the investment instrument level as well as how the instruments are managed at the portfolio level. Thus, a die-hard index fund advocate may be “passive” at the instrument level and “active” at the portfolio management level. Conversely, an investor who utilizes actively managed funds (i.e., instruments) may be passive in his ongoing management of actively managed funds. Viewed in this way, it’s difficult to determine which investor is passive and which one is active.
Here, we explore a twist on the classic active/passive debate by presenting theoretical parameters for the best-case and worst-case outcomes when actively managing a portfolio of passive index-based instruments.
Background And Data
The time frame covered in this study was the 39-year period from 1970-2008. Investment asset classes included in this analysis were seven core indexes: large-cap U.S. equities, small-cap U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, real estate and commodities (see Figure 1).
The 39-year historical performance of large-cap U.S. equities was represented by the S&P 500 Index, while the performance of small-cap U.S. equities was captured by using the Ibbotson Small Companies Index from 1970-78, and the Russell 2000 Index from 1979-2008. The performance of non-U.S. equities was represented by the Morgan Stanley Capital International EAFE (Europe, Australasia, Far East) Index. U.S. intermediate-term bonds were represented by the Ibbotson Intermediate Term Bond Index from 1970-72 and the Lehman Brothers Intermediate Term Bond Index (now called the Barclays Capital U.S. Intermediate Credit Index) from 1973-2008.
The historical performance of cash was represented by three-month Treasury bills. The performance of real estate was measured by using the annual returns of the NAREIT (National Association of Real Estate Investment Trusts) Index from 1970-77. Annual returns for 1970 and 1971 were regression-based estimates inasmuch as the NAREIT index did not provide annual returns until 1972. From 1978-2008, the annual returns of the Dow Jones Wilshire REIT Index were used. Finally, the historical performance of commodities was measured by the Goldman Sachs Commodities Index (GSCI). As of Feb. 6, 2007, the GSCI is now known as the S&P GSCI Commodity Index.
Using the annual performance of these seven passive indexes, the performance parameters of a passive-passive portfolio (buy-and-hold using index funds) were simulated. In addition, the performance parameters of an active-passive portfolio (active management of index funds) were also simulated. The key variable in this analysis is how passive instruments are managed: actively or passively.
Historical Performance
The 39-year average annualized return on large U.S. stocks from 1970-2008 was 9.48 percent. A buy-and-hold investor who chose to invest in only the S&P 500 Index would have turned a $10,000 investment on Jan. 1, 1970 into $341,485 by Dec. 31, 2008 (not adjusted for taxes, inflation or fund expenses).
The performance of U.S. large stocks, as previously mentioned, is represented in this case by the S&P 500, a “passive” index. It represents a typical benchmark against which actively managed funds are often compared. There are several assumptions behind the performance figure of 9.48 percent. First, it implies a buy-and-hold investment with no additional investments or withdrawals. Second, there are no tactical decisions made during the investment period—no overweighting or timing-based buys or sells. It is clear that these strict assumptions would rarely pertain to even the most ardent “passive” investor.
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