It’s Time To Embrace Rational Investing

This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

The great debate in investment circles for the last several years has been whether active or passive investing is a better strategy. Generally, investors are labeled as one of these two categories. Recently, the passive camp appears to have gained the upper hand, as measured by sentiment and positive returns, as even the Michael Jordan of active investing, Warren Buffett, has sung the praises of passive investing. 

However, the debate doesn’t end at passive versus active investing.  So called Quantitatively Enhanced Indexing (QEI) indexing combines positive elements of both styles and represents an approach all investors would be aware of.  

On Being Passive

Before we dive a little deeper, I want to set the table for anyone new to this debate.  If you believe that markets have incorporated all the information impacting the price of a security, i.e. believe in the efficient market theory, then you’re more likely to be a passive investor. Passive investing dictates an investor will be buying and holding securities proportionate to their representation in an index.  Today, Apple, Amazon, Alphabet (aka Google), Microsoft and Facebook are the most valuable companies in the S&P 500 Index and the passive investor has captured the substantial uplift in those stocks. If we apply a global perspective, a passive investor would layer in additional diversification by including non-US holdings. Using the MSCI World Composite Index as a guide one would have 55% of their equity allocation invested in North America and 45% overseas.

Once you have your passive investment portfolio set up, you should see the benefits of low costs and tax efficiency, but keep in mind that without further action you’ll never outperform the market because you essentially own the market.

On Being Active

On the other hand, if you attempt to outperform a benchmark index by buying and selling securities selectively, you’d be considered an active investor. Active investors monitor their investments almost constantly to watch for shifts. They are charged with comparing companies and sectors to one another and basing their selections on that analysis. This, clearly, takes some time out of that investor’s day, so it’s also likely that people involved in active investing are qualified investment managers. That manager’s time also tends to come with a premium cost, which could pay off if your manager does in fact beat the markets. More on that later.

We also have substantial evidence that markets are not always perfectly efficient. This was illustrated in finance professor turned asset manager Mark Carhart’s 1997 paper, “On Persistence in Mutual Fund Performance.”  Carhart showed stocks that went up last year have a likelihood of going up the next year which is the phenomena of momentum that’s well known to investors. The MSCI USA Momentum Index, for example, has outperformed the S&P 500 Index by 5.4% annually since 1975. And this type of evidence appears to have converted Burton Malkiel, author of a “Random Walk Down Wall Street”, which advocated the efficient market hypothesis, to support a less passive approach.

Now, if markets aren’t efficient, why not employ active managers entirely?  While there is a list of managers that have outperformed over 3, 5, and 10 years, the reality is that the persistence of those returns are driven by a variety of factors that can change over time and academics who have studied this topic would argue one actually needs 20-to-25 years of relevant data before deciding if a manager is truly skilled or simply lucky.  Hence, by the time you have enough statistically relevant data to rely on, the manager is likely nearing retirement, retired or dead. Luckily, there’s another strategy you can employ. 

A Third Option

The debate does not end at passive versus active investing styles. There are a myriad of methods being bandied about which investors attempt to employ. Among these methods is a third approach we’ve embraced, Quantitatively Enhanced Indexing (QEI). QEI seeks to leverage inefficient areas of the market, lower cost strategies, and broad diversification into better-than-market returns.  

The thinking behind QEI is that if momentum stocks have outperformed the market in the past, then having more momentum stocks in your portfolio will get you a higher return. More broadly, by tilting portfolios toward specific traits, such as value, momentum, quality/profitability, small cap and low volatility, there may be a better chance of outperforming a passively-indexed portfolio over time.

The QEI approach has several benefits. First, the tax and cost benefits are comparable to passive indexing. Next, not only have the various characteristics (value, momentum, etc.) been effective indicators of performance over the long term, but there are strong behavioral reasons why those returns may persist. Take the example of value stocks. One reason they tend to be cheaper is because these stocks are in out-of-favor or unglamorous industries, or have been subject to negative headlines. Fewer investors are willing to steer into headwinds, hence the higher expected returns to value.

Of course, departing from a market-weighted portfolio introduces the possibility of underperforming the market as well. As recently as 2014, value and momentum stocks did worse than the market at large. This brings us back to a bedrock principal of investing: to have a chance for long-term outperformance, investors must be willing to accept the risk of short-term underperformance. After all, the excess return above passive indexing is a reward for deviating from the market weights and taking a positional risk that the market as a whole doesn’t want to take. 

At the end of the day, there is no debating the investment industry is populated by intelligent, hard-working people and a variety of solutions can appear to be attractive on the surface.  What is attractive may not be the most rational. We believe there are two things that characterize the best investment management programs: a strong framework for making investment decisions and the discipline to adhere to that framework through inevitable periods of market volatility. And the best of the best dedicate their time to items that are in their ability to control, such as taxes, costs, and risk budget, which are part of the fabric of a Quantitatively Enhanced Indexing approach.  

Investing involves risk, including the risk of loss. All indexes mentioned are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance on any investment. Past performance is no guarantee of future results.

Click here to see the article on Forbes.

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