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The issue of active vs. passive investing typically centers
on the nature of the actual investment product: “Is it
an actively managed fund or a passive index fund?”
However, this is only one aspect of the active vs. passive
debate, and presents far too simplistic a view. There is a
broader, macro issue that applies to the broad portfolio;
namely, “How is the portfolio of actively managed funds or
index funds managed over time?”
For example, if there is a large amount of turnover in a
portfolio of index funds, it is an actively managed portfolio
of passive index funds. Very simply, it is an “active-passive”
portfolio. By contrast, an investor who purchases index funds
using a buy-and-hold approach has a “passive-passive” portfolio.
In short, it is possible to be an active manager of passive
funds, or a passive manager of actively managed funds.
In sum, the terms “active” and “passive” can apply to
the nature of the investment instrument level as well as
how the instruments are managed at the portfolio level.
Thus, a die-hard index fund advocate may be “passive” at
the instrument level and “active” at the portfolio management
level. Conversely, an investor who utilizes actively
managed funds (i.e., instruments) may be passive in his
ongoing management of actively managed funds. Viewed
in this way, it’s difficult to determine which investor is
passive and which one is active.
Here, we explore a twist on the classic active/passive
debate by presenting theoretical parameters for the bestcase
and worst-case outcomes when actively managing a
portfolio of passive index-based instruments.
Background And Data
The time frame covered in this study was the 39-year
period from 1970-2008. Investment asset classes included in
this analysis were seven core indexes: large-cap U.S. equities,
small-cap U.S. equities, non-U.S. equities, U.S. intermediateterm
bonds, cash, real estate and commodities (see Figure 1).
The 39-year historical performance of large-cap U.S.
equities was represented by the S&P 500 Index, while the
performance of small-cap U.S. equities was captured by
using the Ibbotson Small Companies Index from 1970-78,
and the Russell 2000 Index from 1979-2008. The performance
of non-U.S. equities was represented by the Morgan
Stanley Capital International EAFE (Europe, Australasia,
Far East) Index. U.S. intermediate-term bonds were represented
by the Ibbotson Intermediate Term Bond Index from
1970-72 and the Lehman Brothers Intermediate Term Bond
Index (now called the Barclays Capital U.S. Intermediate
Credit Index) from 1973-2008.
The historical performance of cash was represented by
three-month Treasury bills. The performance of real estate
was measured by using the annual returns of the NAREIT
(National Association of Real Estate Investment Trusts)
Index from 1970-77. Annual returns for 1970 and 1971 were
regression-based estimates inasmuch as the NAREIT index
did not provide annual returns until 1972. From 1978-2008,
the annual returns of the Dow Jones Wilshire REIT Index
were used. Finally, the historical performance of commodities
was measured by the Goldman Sachs Commodities Index
(GSCI). As of Feb. 6, 2007, the GSCI is now known as the S&P
GSCI Commodity Index.
Using the annual performance of these seven passive
indexes, the performance parameters of a passive-passive
portfolio (buy-and-hold using index funds) were simulated.
In addition, the performance parameters of an active-passive
portfolio (active management of index funds) were also simulated.
The key variable in this analysis is how passive instruments
are managed: actively or passively.
Historical Performance
The 39-year average annualized return on large U.S.
stocks from 1970-2008 was 9.48 percent. A buy-and-hold
investor who chose to invest in only the S&P 500 Index
would have turned a $10,000 investment on Jan. 1, 1970
into $341,485 by Dec. 31, 2008 (not adjusted for taxes,
inflation or fund expenses).
The performance of U.S. large stocks, as previously
mentioned, is represented in this case by the S&P 500, a
“passive” index. It represents a typical benchmark against
which actively managed funds are often compared. There are
several assumptions behind the performance figure of 9.48
percent. First, it implies a buy-and-hold investment with no
additional investments or withdrawals. Second, there are no
tactical decisions made during the investment period—no
overweighting or timing-based buys or sells. It is clear that
these strict assumptions would rarely pertain to even the
most ardent “passive” investor.
The performance of several additional “passive” benchmarks
is presented in Figure 1, such as the EAFE index, the
Russell 2000 Index and so on. Figure 1 also includes the
performance of several buy-and-hold multi-index portfolios.
The first portfolio is a 40/60 allocation, representing a 40
percent allocation to U.S. large stocks and a 60 percent
allocation to bonds. This allocation represents a typical
“income” fund or conservative balanced fund. Here, the
40/60 portfolio had a 39-year annualized return of 8.74 percent,
assuming the two allocations were never rebalanced
back to the original 40/60 allocations.
The next multi-index portfolio is a 60/40 allocation,
representing a 60 percent allocation to U.S. large stocks
and a 40 percent allocation to bonds. This is a common
allocation in a “balanced” fund. A $10,000 total investment,
where $6,000 was invested in the S&P 500 and $4,000 was
invested in the bond index in 1970 (and not rebalanced
over the intervening 39 years), produced an ending total
combined balance of $289,144, for a 39-year annualized
return of 9.01 percent.
The third multi-index portfolio consists of equal allocations
to each of the seven core indexes. It will be referred
to as an equal-weighted seven-index portfolio. Multi-asset
portfolios are often referred to as “asset allocation” funds.
This multi-index portfolio had a 9.37 percent average
annualized return over the 39-year period. It should be
pointed out that asset allocation funds seldom employ
equal weighting among the various assets in an asset allocation
fund. Based on the results in Figure 1, one might
reasonably ask “Why not?”
www.journalofindexes.com January/February 2010
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