USA TODAY International Edition
Be more proactive with your 401(k)
Weigh pros and cons of passive, active investing
The late, great Jack Bogle of Vanguard once called passive investment “the greatest invention in the history of finance.”
His legendary career thrived upon this premise. Now, conventional wisdom commonly believes passive management beats active – and fund managers aren’t worth their fees. Yet a recent study of active manager performance by consulting firm Wilshire Associates debunks parts of this belief. Many active managers actually did very well this last decade.
I’m not arguing here for active or passive. But how and why some active managers achieved their success offers you actionable tips to deploy in your 401(k) or other retirement portfolios.
Passive’s prophets primarily presume active equals stock-picking. They rightly argue markets are too efficient for anyone to repeatedly pinpoint needles in our stock market haystack. Yet, whether an active manager outperforms is less about getting stock picks right than about identifying – and capitalizing on – a benchmark’s quirks (like those of the Standard & Poor’s 500 or any index).
Take the 1990s, as Japan’s stock market bubble burst. Any globally diversified investor (which you should be) could beat that decade just underweighting Japanese stocks. Japan started 1990 totaling half the money value of the world’s stock market. Crazy! You needed nothing else to beat the world than underweighting Japan.
View Wilshire’s study in this light, and its findings aren’t surprising. For instance, 79% of small-cap growth managers beat their indexes over the past five years. Skill? No. This, too, is wonkiness. The biggest stock in MSCI’s US Small Cap Growth Index has a market capitalization of $10.2 billion. Many small-cap managers own much bigger, but still relatively small stocks. Why? It’s less strategy and more necessity.
Most fund firms struggle to trade tiny stocks without moving the price significantly. So they end up owning many stocks bigger than their benchmarks. When larger stocks beat smaller ones – as they have lately – active small-cap managers outperform.
This also explains why their relative returns were worse going further back – small stocks beat big ones early in this bull market, as they usually do early on. Managers’ skewing to slightly larger stocks hurt them then as this bull market launched. A few lousy years early! A few great ones later! Cycles happen.
Going passive is cheap, smart and often truly better, as Bogle always said. But Wilshire’s report shows the benefits of hedging passiveness based on style and size. Be passive with one chunk and active in another to avoid index craziness. The trick? Understanding index quirks. Most major index providers such as MSCI, S&P or Russell offer online fact sheets detailing their indexes’ construction. These tools help you spot crazy wonkiness to hedge against.
Expecting U.S. stocks to hugely lead or lag foreign ones? Then adjust your U.S. holdings above or below America’s 63% global weight. Or maybe lower them down to 55% or up to 70%. Many readers probably think underweighting America now is stupid, given that we’ve beaten foreign stocks lately.
But that is almost 100% because of America’s huge tech dominance. Strip it out – then U.S. and foreign returns nearly match. Expect that to persist? Emphasize tech among American holdings while overweighting non-tech overseas.
You can do all this and more with individual stocks or exchange-traded funds (ETFs) from iShares or State Street’s SPDR. Be passive and active – just be proactive, not reactive.