Active equity investors have had it tough. The S&P 500 dropped 10% in the first six weeks of the year before recovering ground in February and March to close the quarter up a mere 0.8% (boosted to a total return of 1.3% when taking dividends into account). Active managers build portfolios that intentionally differ from the composition of an underlying index, and these efforts have generally fallen short of a passive approach that simply mimics an index. Using the Vanguard 500 Index Fund as a passive comparison, only 24% of active funds have outpaced the market so far this year, and just 21% have done so over the past five years.1 Investors have responded to this performance shortfall by voting with their wallets, withdrawing $259 billion out of active equity funds over the past year while investing $185 billion in passive approaches.2 The proliferation of passive mutual funds, exchange-traded funds and target date funds (designed to match expected retirement dates) forms an unprecedented assault on the wisdom or even necessity of active investment management.

In the pages that follow, rather than rehearse the timeworn debate between passive and active investing, we instead explore why passive investing has succeeded and consider the insights that we as active investors may derive from that success.

Lethargy Bordering on Sloth

Much of the benefit of passive investing can be attributed to low turnover. Turnover is a measure of activity, or how much the composition of a portfolio changes year to year. The calculation is simple: the lower of net purchases or sales over the past year divided by the total net asset value of the fund. For example, 25% turnover implies that a quarter of the portfolio’s value changes annually, or, conversely, that the average holding period for positions in the portfolio is four years. Active managers buy and sell as opinions change, whereas passive managers only buy and sell as the composition of the index changes – and that doesn’t happen very often. The turnover of active managers is therefore almost always higher than passive managers. It is not uncommon for an actively managed mutual fund to have turnover between 50% and 100%, the latter figure indicating that the annual trading volume is equal to the size of the fund. In juxtaposition, the turnover of the Vanguard 500 Index Fund is a mere 3%, in line with the stability of the underlying index. Herein lies an important contributor to the relative success of passive investing.

Buying and selling stocks costs money and therefore acts as a drag on performance. In addition to per-trade commission charges, investors “pay” the invisible cost of the spread between the asking and offering price of a security. This drag has admittedly diminished over time as commissions shrink and spreads (at least in liquid markets) have narrowed, but small costs can multiply to big costs in an investment strategy that requires frequent trading. A recent Morningstar study concluded that trading costs reduce the performance of the average active equity fund by between 10 and 20 basis points3 (bps) per year.4 That’s not a huge burden, but those small costs compound over time and rise with the frequency of trading.

Investors pay commissions on the day of a trade but often pay again much later – and much higher – when they receive the tax bill for capital gains incurred through trading. Depending on her state of residence and level of income, an investor may owe the tax authorities as much as 33% of her capital gain (in California), or even more if the gain is from a position held for less than a year. Leaving aside the variety of state and local taxes, federal taxes alone add up to 20% of long-term capital gains plus the 3.8% Medicare surtax applied to net investment income for taxpayers with incomes over $200,000 (for single filers) or $250,000 (for married couples filing jointly). Lower turnover reduces trading costs, but the far larger benefit is that it allows more of your money to keep working for you by not trading, realizing gains and paying taxes on those realized gains.

Consider the examples illustrated in the nearby graph. A $1 million portfolio earning an average annual return of 6% compounds to $1,766,868 over a 10-year period, assuming modest annual turnover of 10% and a capital gains tax rate of 23.8%. If we hold all of those assumptions constant while raising the turnover to 50%, the portfolio only grows to $1,673,810 over the same time period. Higher turnover alone costs the second portfolio $93,058 over the course of a decade, equivalent to an annual performance drag of 60 bps. In this simple example, every 10% increase in turnover costs the portfolio 15 bps of annual performance. Low turnover is a powerful tailwind to performance – and one that most active investors don’t take advantage of.

Q2_2016_The_Effect_of_Turnover_on_Portfolio

A final and far more subjective benefit of low portfolio turnover is psychological. Behavioral psychologists have compiled a long list of repeatable and predictable ways in which human beings act contrary to their own interests. Among other tendencies, we have too much confidence in our own opinions, naturally seek confirmation of our beliefs while ignoring contrary evidence, place too much importance on available information, see patterns where none exist and generally believe that we have far more control over our future than we actually do. To make matters worse, we are more likely to fall prey to these biases when we make decisions based on incomplete information and under time pressure – two conditions that define the act of investing.

This isn’t to say that we are stupid, but that we are normal, and furthermore that Seneca the Younger had it right when he observed errare humanum est (to err is human). Put differently, the fewer decisions you make, the fewer mistakes you make. A low-turnover approach simply reduces the opportunity for error. It is easy to succumb to the lure of a hot new stock, particularly when a friend or in-law brags at a cocktail party about how well it has performed and how much money he is making. A real benefit of passive investing is that no one in the history of cocktail parties has ever bragged about the hot new index fund he bought.

And yet passive investing is not a sure cure for behavioral biases. Indeed, studies show that whereas the average return of an index fund is obviously the performance of the index (minus modest fees), the average return of an index fund investor is several percentage points below the index. How can this be? Passive investing diminishes, but doesn’t remove, behavioral bias. We are still tempted to buy high and sell low, whether investing actively or passively.

Rigorous discipline is a vaccine against behavioral bias. It enables us to avoid being misled by the instinctive, emotional and reactive part of our nature – labeled as “System 1” in Thinking, Fast and Slow, Daniel Kahneman’s best-selling summary of the field of behavioral economics – and to replace it with the patient, analytical and deliberative thought that Kahneman calls “System 2.” This is not easy, and the benefit of passive investing is that it more or less does the job for us by reducing the opportunity for error. Indeed, the difficulty of overcoming bias through patient discipline is almost certainly why in his 2014 letter to Berkshire Hathaway’s shareholders, Warren Buffett wrote that he would instruct the trustees of his estate to invest in index funds. He of all people knows just how hard it is to maintain discipline in the face of volatility and emotion.

A passive investment approach based on a stable underlying index provides an investor with the benefits of lower trading costs, more efficient tax treatment, better opportunities to compound returns and less risk of emotional interference. Based on the earlier examples, we’ve seen that lower turnover explains almost a full percentage point of the return advantage historically enjoyed by passive investing. And yet these advantages are also available to active investors who avoid the temptation of frequent trading in favor of a more patient and disciplined approach. To quote once again from a letter to shareholders, Buffett memorably and poetically affirmed in 1990 that “lethargy bordering on sloth remains the cornerstone of our investment style.” The analysis is quite clear: High-frequency trading can be hazardous to your wealth.

Daring to Be Different

The inability of most active managers to consistently beat an index reflects yet another behavioral bias: regret avoidance. In an attempt to avoid significant (and perhaps career-ending) underperformance, many active managers are reluctant to stray too far from the index against which they’re being measured. Conventional success in money management leads to job security and raises. Even failure, if conventional enough, leads to job retention. An older generation of institutional investors routinely joked that a portfolio manager would never get fired for owning IBM. No matter how poorly the stock performed, so many portfolios owned it that there was safety in numbers. Replace IBM with any one of the widely held stocks today, and the lesson still stands. We are, after all, a herd species.

An old Wall Street adage holds that it is far better for a professional investor to succeed unconventionally than conventionally. Unconventional success leads to fame and glory. The manager who took a risk on the young Amazon, Apple or Google rose to prominence, appeared on the covers of trade journals and became an investment legend. Yet unconventional success requires one to assume the risk of unconventional failure, and unconventional failure leads to getting fired. Most managers prefer to fail conventionally and keep their jobs rather than assume the risks required to succeed unconventionally. The poor track records of most actively managed funds reflect this desire to avoid the regret of being unconventionally wrong. For most institutional managers, job preservation trumps wealth preservation.

The degree of a portfolio’s unconventionality can be measured through a concept called active share, which quantifies the extent to which a portfolio differs from an index. To be precise, active share is the sum of the absolute differences between the weights of each stock in an index vs. a portfolio, divided by two. An index fund that perfectly replicates the index has an active share of 0%, whereas a portfolio that owns no names in common with its relevant index would have an active share of 100%. Mimicking an index, as reflected by a low active share, magnifies the performance drag associated with turnover, making it difficult for managers to beat an index even before a higher level of fees is taken into account.

Conventional wisdom holds that portfolios with higher active shares are riskier, yet this conclusion implies that risk is defined by deviation from a benchmark. This definition of risk lies at the foundation of modern portfolio theory, stretching all the way back to Harry Markowitz’s seminal paper on portfolio selection published in 1952. Is it any wonder that many portfolio managers address both portfolio and career risk by sticking close to the index against which they are measured? The incentive structure for much of Wall Street is based on this understanding of risk, one that arguably creates misaligned incentives between portfolio managers, who want career stability and progress, and their clients, who want to see their capital grow.

True active managers define risk as a permanent loss of capital and manage it by willingly deviating from the benchmark. In most cases, this results in a concentrated portfolio of companies and high active share, which increases the potential for superior returns. It is important to note that high active share does not guarantee superior returns; it simply magnifies the impact of investment insight, either for better or worse. Concentrated portfolios furthermore offer additional protection against the behavioral biases outlined earlier. The temptation to sell a company into weakness diminishes when you know its underlying value so well that price volatility doesn’t shake your conviction. A firm handle on the fundamentals makes it easier to resist the temptation of the herd.

What are the common characteristics of unconventional managers? First, they tend to embrace the benefits of low turnover that we’ve already seen. They appreciate the power of compounding and have the discipline to hold stocks that are performing poorly – or even take advantage of price volatility by adding to those positions. Second, they tend to have a substantial portion of their own wealth invested alongside their clients. They’re not interested in launching new mutual funds and attracting billions of dollars of assets because the performance of their portfolio over the long run is a more important driver of their own wealth. They understand that at some point more assets under management begins to dilute returns and are willing and eager to close to new clients in order to preserve the efficacy of their investment approach. Finally, they tend to be privately owned firms that care more about the sustainability and growth of their business than job security. The peculiar incentive to fail conventionally and keep your job doesn’t apply when you are your own boss.

These managers don’t aggressively market their track records, and those records are therefore largely absent from the databases that analysts rely on to argue for the superiority of passive over active investing. If those databases were expanded to include less conventional managers who assume higher active share, we wonder if the returns of passive investing would look as competitive.

Even Charles Ellis, the prolific writer on investment themes and advocate of passive investing, acknowledges:

[A] few specialist managers appear to have found creative ways to exploit the very market forces that confound most large active managers. However, such managers are small in capacity, hard to identify in advance, and limited in how much they will accept from any one client or even closed to new accounts. … Meanwhile, most large investment managers are obliged by their size to invest primarily in the 300 stocks most widely owned and closely covered by experienced portfolio managers and expert analysts.5

We couldn’t agree more.

Having Your Cake and Eating It Too

Advocates of passive investing usually blame fees for the underperformance of active managers and rhetorically question why anyone would willingly pay up for below-market performance. After all, the Vanguard 500 Index Fund referenced earlier levies a mere 11 bps in management fees on its shareholders and has outperformed most active funds. We agree with the implication behind the question – investors shouldn’t pay up for investment strategies and structures that make the challenge of preserving and growing wealth more difficult than it already is. Most managers underperform because of high turnover, closet indexing and the fear of being unconventionally wrong. Those attributes aren’t worth paying for.

And yet investors can have their cake and eat it too. Many benefits of passive investing, such as low turnover, tax efficiency, compounding returns and resistance to behavioral biases, can be obtained through active approaches. Concentration and high active share are ingredients for investment success, although it takes the right combination of discipline, skin in the game and independence to encourage a manager to stray from the herd in pursuit of superior returns. Investors should always gauge the skill of an investment manager based on after-fee returns, and we conclude that managers who share these characteristics of success warrant the fees they charge, while admitting that there simply aren’t that many of them out there.

These few paragraphs won’t settle the debate between active and passive investing; proponents on both sides cling to their arguments as if they were articles of faith. As active investors, we appreciate the challenges associated with providing superior returns and readily acknowledge that there are lessons to be learned from the growing success of passive investing that will make us and our clients better investors.

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© Brown Brothers Harriman & Co. 2016. All rights reserved. 2016.

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1 VFINX Equity U.S. DES on Bloomberg. Accessed 12 Apr 2016.
2 Twelve months through February 2016. Source: Morningstar Direct.
3 A basis point is equal to one-hundredth of 1%.
4 Kinnel, Russel. “It’s Flowmageddon!” Morningstar.com. 7 Apr 2016.
5 Ellis, Charles. “The Rise and Fall of Performance Investing.” Financial Analysts Journal 70.4 (2014).