2023 Q2 Quarterly Market Review – Active vs Passive Investing

By Schultz Collins Investment Counsel on July 28, 2023

Equities, in general, experienced positive gains in the second quarter of the year, despite continued financial, recessionary, and inflationary uncertainty.

The MSCI ACWI Index, a proxy for major stock markets around the world, rose 6.35% for the quarter, and 17.14% over the trailing 12-month period.

The S&P 500, a proxy for large US stocks, posted gains of 8.74% for the quarter, and 19.61% for the last 12 months. US small company stocks, represented by the Russell 2000 Index, returned 5.21% for the quarter and 12.32% year-over-year.

The Dow Jones US Select REIT Index, an index of real estate investment trusts, gained 2.92% for the quarter, but lost 0.69% for the trailing 12 months.

Stocks in international developed countries, represented by the MSCI EAFE Index, experienced a 3.22% gain for the quarter, and 19.42% for the trailing 12 months. Stocks in international emerging markets countries, as proxied by the MSCI Emerging Markets Index, produced a 1.04% gain for the quarter and a 2.22% gain over the last 12 months.

The Federal Reserve increased interest rates again in the second quarter. With the rise in rates, US bonds, as measured by the Bloomberg US Aggregate Bond Index, fell 0.84%; the Index is down 0.94% year-over-year. Bond prices typically fall when interest rates rise, all else equal. The FTSE World Government Bond Index slid 1.79% in the quarter, bringing its 12-month return to -2.49%. The Bloomberg US Corporate Bond Index, a measure of the market in intermediate term corporate bonds, fell 0.16% in the second quarter, but is up 1.85% over the last 12 months.

The yield on the 10-year Treasury note rose, from 3.48% on March 31^st to 3.81% on June 30^th. The yield on the 10-year Treasury is an important benchmark for lending matters like mortgage rates. Higher yields make it more difficult to borrow.

The theme for this quarter is the comparison of active investment management versus passive investment management, also known as index investing.

Active versus Index Investing Revisited:  

The returns recently realized by some of the most widely known stocks might lead investors to question whether picking their favorite 10 to 20 stocks is now a better strategy than investing in broadly diversified indexed or passively managed funds. So perhaps now is a good time to revisit the subject of active versus passive investing.

The debate between index investing and active management will probably never end. In fact, one might argue that actively managed funds will always be with us simply because our culture almost demands it. After all, in general, our society promotes the notion that each of us will be rewarded with outsized economic benefits if we work hard or harder than the average person. While that might be true in many scenarios, does it apply to actively managed investment strategies?

We want to believe that spending hours upon hours reading annual reports and stock charts will enable us to identify superior companies; then, we will be rewarded with above average profits because we bought their stocks. If that is possible, then professional investors and their clients should benefit most and watch as unusual profits pile onto their quarterly or annual statements. This seems rational since the investment professionals who manage active funds spend their whole day and career looking for superior opportunities in the market.

First, let’s be clear about our definitions.

Is this belief well founded?

Index or passive investing involves tracking a broad market index or asset class, aiming to match its performance. In general, indexes are created with little or no bias and are composed of companies that the index provider determines best reflect the economy or a section of the economy.

Investors might be surprised to learn that the constituents of an index don’t frequently change. In fact, indexes commonly replace 3% or less of their constituent securities each year. With little change to an index – referred to as turnover – it should be no surprise that index funds generally have low fees.

Active management, on the other hand, involves selecting investments with the goal of outperforming the market or section of the market. In general, active management assumes a team of professional investors can consistently identify mispriced securities that will one day be discovered by the broad market and provide above average returns for their investors. Doing so often comes with higher costs to pay those managers.

Let’s look at some data and see how well the actively managed funds have performed.

One prominent annual study of mutual fund performance is the SPIVA Scorecard, which is published regularly by S&P Dow Jones Indices. SPIVA stands for S&P Indices Versus Active. The report analyzes the performance of actively managed funds against the S&P 500 Index or their respective benchmarks.

Image 9, labeled at the bottom left, compares all large cap funds versus the S&P 500 Index. 2022 saw an almost even split between those funds that underperformed versus those that outperformed the Index: about 51% of funds underperformed it. Sounds like the odds of flipping a coin.

However, given that 59% of the index constituents outperformed the Index and 30% outperformed it by 20% or more (Exhibit 6), it appears 2022 was a year that should have produced much greater success for active managers than what could be realized by flipping a coin 100 times.

But this was the return of a single year. Surely, there is value to be gained in analyzing annual reports and charts of many companies over various periods of time. There must be rewards for portfolio managers working so hard.

Over various time horizons, and even excluding those funds that failed or were merged into other funds, the results don’t seem to show this to be so. The SPIVA report indicates that a significant majority of actively managed funds failed to outperform the S&P 500 benchmark.

In Image 11, we see that 74.27% of managers underperformed the Index over 3 years.

Over 5 years, 86.51% of managers underperformed the Index (Image 12).

Over 10 years, 91.41% of managers underperformed the Index (Image 13).

Over 15 years, 93.40% of managers underperformed the Index (Image 14). It appears finding the best performing stocks by those highly trained to do so is about as successful as treasure hunting in a state park.

But the sophisticated investor would rightly point out that not all equity managers seek the risk and returns of the S&P 500. She would ask, “How have managers performed against their appropriate benchmark?”

Here in Image 15, we see funds in each asset class compared to their respective benchmarks. Clearly the data are no better. Over the 3, 5, 10, 15 and 20-year period ending 2022, based on the number of funds that survived each period, active managers struggled to beat their respective benchmarks. Most surprisingly, over the last 20-years, between 87% and 97.7% of funds underperformed their respective benchmarks.

What about international equity managers? Market participants might reasonably believe that information needed to make sound investment decisions is not easily obtained in some foreign markets so active managers might be more likely to provide additional returns on those markets, versus their indices. The data in Image 16 tells us otherwise. Over the same 20 years period, between 84.85% and 97.01% of managers failed to beat their asset class index.

The recent data clearly support our longstanding recommendation that investors emphasize passive or index investing. Investors seeking greater returns should focus on the tradeoffs implicit in increasing the level of risk they are willing to assume in a broadly diversified portfolio (such as a passive approach provides), rather than relying on traditional active management strategies that are no more successful than treasure hunting.

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