Tom Lydon and Anu Ganti from S&P sat with Bob Pisani on ETF Edge for a pretty long discussion about the extent that active managers are performing better this year against passive indexes than they have in quite a while. That's actually not a ringing endorsement because it's pretty close to 50/50 which again, better than active has done in a while.
These types of conversations happen all the time and while they are relevant for plain vanilla mutual funds that are fully invested in stocks, trying to beat the S&P 500 or some other broad index they are not relevant to investors selecting tools to construct a portfolio to help them navigate through whatever they are trying to navigate through.
These days, if a fund is selling the prospect of alpha from picking superior stocks, yeah that is a tough sell. There are many different directions to go with active management though. I think most investors who call themselves passive are actually using index funds in active strategies. If you own one equity index fund and one bond index fund and rebalance once a year, that's an active strategy. I'm not bashing that, not even a little, more like making the point that the labels are not useful to most of us.
For plain vanilla, capturing beta, equity exposure then yes going cheap with index funds certainly makes sense. Index could mean broad indexes or narrow like a sector, industry or theme. They tend to be much cheaper than actively managed plain vanilla, capturing beta, equity exposure and per the studies discussed in the link, the indexes outperform.
Of course, individual stocks will be cheaper but how comfortable are you adding in some single names? No wrong answers, how comfortable? Right now, generically speaking, I own about twice as many individual stocks as I do narrow based ETFs for clients with 5 or 6 diversifiers. For fixed income I used to own a lot more individual issues when yields were a little higher, then pretty much all funds for a while and I've recently added some short dated individual issues as yields have gone back up.
This morning I had a conversation with a client about what it going on in the market and their accounts. At one point they asked how their stocks are doing. A couple are doing well (a diversified portfolio should have at least one or two stocks still up) but they generally are going to be down with the market. What matters, I said, is how much we have in equities and how much we have in diversifiers. We're underweight equities on a net basis versus the target allocation as we've been writing about for months. This is a top down process.
Any sort of top down decision will either be right or wrong of course but in using tools to reduce net exposure, mostly how I do it, it doesn't matter whether the fund generates alpha, that's the wrong question. The right question is whether the fund, the tool, is doing what you expect it to do.
Here are the two most recent diversifiers I added into client accounts fairly recently, the chart is YTD versus the S&P 500. I would hope a VIX proxy like VIXM would go up a lot when stocks go down and I've described several diversifiers, like PPFAX, as being a horizontal line that hopefully tilts upward. I think we're up 8 cents on it since we bought, slight tilt up. Using products like this is obviously part of an active strategy. When diversifiers like these are outperforming the S&P, I won't even call it alpha, it means the index is doing poorly. You don't want these things doing well, you do not want them generating "alpha," it means everything else is not working out at the moment.
I have no idea whether the active/passive studies include fund that are not intended to outperform standard benchmarks tracked by index funds because I don't think it matters.
Long time client holding, Discretionary Sector SPDR (XLY) has wildly outperformed the S&P 500 in just about any period you want to look at. The sector tends to outperform to the upside but it also does worse, usually, to the downside as is the case in 2022. It's about 500 basis points behind the SPX. When this event is over, I would expect discretionary to again outperform just because that's normal market activity; better to the upside, worse to the downside. It's an index, a narrow index, should the concept of alpha even come into play for basic exposure? Obviously it would be considered a passive fund if the studies do include it but the performance is very likely to be very similar the vast majority of the time; better to the upside, worse to the downside.
If you want to dampen portfolio volatility, there are all sorts of tools to add in. Some don't really work well very often but you can get a sense of which ones work more often than not. You can't expect infallibility which is why I think you want to diversify your diversifiers. The other risk is you are wrong about the timing and the market goes up instead of down. Right now everyone expects the stock market to keep going down, I do, but what if it doesn't? I say frequently about this type of active management, including on the client call this morning, on the way up you're too hedged and on the way down you're not hedged enough. That's the nature of it.
Forget alpha, focus on building a strategy you think is simple, you can stick with and gives you your best shot to reach your goal.
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