It seems like there are a lot of lessons to be learned from the stock market of the past several years. The pitfalls of "irrational exuberance." The folly of bubbles. Day-trading, quick-hit IPOs, speculation run amok.
But what about the old passive vs. active management argument? Has the riches-to-rags market shed any light on this debate? As you might guess, it depends on whom you talk to. For someone like Mario Gabelli, chairman and CEO of Gabelli Asset Management Inc. and a vocal critic of passive management for more than a decade, the verdict is clear. "The answer is passive investing has experienced three down years in the market," Gabelli says. "The bear market is exactly what underscores what's wrong with passive investing."
Indeed, the promise of passive investing has always been the return of the market-no more and no less. And in times like these, that's not going to get anyone real giddy. Take the Vanguard 500 Index Fund, which as expected is paralleling the S&P 500 Index with a year-to-date loss of more than 19% as of late August. This follows a decline of 12% in 2001 and 9.1% in 2000.
Other index funds also are lagging, in some cases behind their active-market competitors. The Vanguard Small Cap Index Fund is down 18%, compared with an average loss of about 15% for the overall mutual fund sector, according to Morningstar.
As corporate accounting scandals have shocked the nation in recent months, some like Gabelli suggest that the trend toward passive investing among both institutional and retail investors contributed to the magnitude of fraud. With fewer active managers out there to kick the tires and look under the hoods, it became easier for managements to perpetrate accounting scams, Gabelli and others argue.
"Active managers are the watchdogs," he says. Maybe so, but how much fraud did they actually uncover? Perhaps the best that can be said for active managers is that some of them bailed out of companies where the books "didn't feel right." And only in some cases. One of the most popular stocks among institutional investors was Tyco, hardly a model of accounting integrity.
Still, in a market in which it seems everyone is hurting, passive investors appear to be getting stung slightly more. The bottom line in Gabelli's eyes: In a down market, passive investors have no chance at all. "For some investors, buying a basket of stocks and passively holding them may be a good way to diversify," he says. "But it is mindless investing."
But don't tell that to John Bogle, the founder and former CEO of The Vanguard Group and a frequent sparring partner of Gabelli when it comes to arguing the merits of passive investing. Critics of passive investing in the bear market are looking through too narrow a lense, Bogle insists.
Conveniently ignored by the critics is the role active managers played in the creation of the technology bubble and the subsequent correction that plunged investors into a bear market of staggering proportions. During the run-up of the market in the late 1990s, he notes, aggressive-growth technology and Internet funds sucked up $245 billion in new capital. In that time alone, he says, 500 new funds of that type were born.
Bogle recalls with irony how, in March 2000, he opened a copy of Money magazine and saw a family of funds advertise how they averaged an 85.6% return the previous year. "If that isn't pandering to the public taste, you have to tell me what is," Bogle says. "Active managers have an awful lot to answer for."
That's why, he says, the redemption rates are twice as high for active funds as they are for index funds. It is also why, he adds, that one would be hard pressed to find a passive investor who has lost 30%, 40% or more, as is the case with some active funds. "People are flocking away from active management," he says. "They have gotten badly burned." However, the decline from peak to trough in Vanguard's Standard & Poor's 500 Index exceeded 40%, so it's hard to say they did much better.
When it comes to comparing returns, many critics fail to account for costs, which can significantly skew results, Bogle says. An active fund costs an investor an average of 240 basis points a year when factors such as transaction costs are weighed in, Bogle maintains. Bogle's estimate of the average expense ratio is higher than most estimates, but his point is accurate. Over the long run, he says, that takes a significant bite from returns. Using the 12% annual return of the S&P 500 over the past 50 years as a base point, Bogle says those costs leave investors with a true return of 9.6%. Compounded annually over the past 50 years, each dollar in the S&P 500 would have grown to $287, compared with $96 for an actively managed fund. When inflation is taken into account, the real return drops further, he says. "After costs, they absolutely go down more than index funds," he says.
The cost factor becomes even more extreme with hedge funds, which Bogle feels are among the worst forms of actively managed vehicles.
Overall, neither passive nor active is a clear winner in this bear market, says Peter Di Teresa, senior editorial analyst at Morningstar. In many ways, he says, index funds are performing the way they'd be expected to during a down market. "The key to think about is, how do they do over the long haul?" he says.
Academic studies have indicated value is the performance winner, on average, over long durations. But Di Teresa notes that studies have also indicated that active managers do better against their passive counterparts in the mid- and small-cap arenas. "What makes sense for a portfolio is to use a combination of the two," he says.