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Fact Check: Can Only an Active Portfolio Really Provide Downside Protection?

A friend recently sent me an email from a broker with a very large brokerage firm. Let's protect the guilty and call the firm "Global Investments." The goal of the email was to get my friend to hand over his portfolio so it could be actively managed. The email read something like this:

I would ask Mr. Roth how his second grader's index portfolio fared in 2008. The crux is that indexing got hammered.
Indexing is a double edged sword. It is true that you get all of the upside but you also get all of the downside. The most significant part of our charter here at Global Investment Corp. is managing risk and the downside. Only an active portfolio can protect from a down market. Now is the time for active management!
This broker is arguing that active managers know when to get into and out of the stock market. The logic, if you can call it that, is that an index stock fund will get creamed while an active manager will anticipate and get out of the market before the fall. This broker's claim, however, has three strikes against it.

Strike One: Arguing that indexing underperformed active in 2008
Index funds suffered badly in 2008, but did they really do worse than active funds? Surely Global Investments' compliance department wouldn't have allowed him to send out this email if it weren't true -- or would they? Let's compare the 2008 performance of the three index funds in the Second Grader's portfolio to the average mutual fund performance, as calculated by Morningstar.

  • Vanguard Total Stock (VTSMX) -37.0%, Avg Domestic Equity -39.0%
  • Vanguard Total International (VGTSX) - 44.1%, Avg International Equity -45.7%
  • Vanguard Total Bond (VBMFX) +5.1%, Avg Taxable Bond -8.0%
I bet it's a real pebble in the shoe of Global's compliance department when the data gets in the way of their statements. Professionally managed stock funds captured about 105 percent of the market downside. Bond managers got majorly creamed trying to add value by buying AAA rated sub-prime garbage. Take the Schwab Yield Plus bond fund which was billed as a safe alternative to money markets and lost more than 35 percent of its value last year.

Strike Two: Arguing against simple arithmetic

This broker argues that now is the time for active management. And to reinforce that argument, the broker includes an attachment attacking the efficient market hypothesis (EMH). The EMH asserts that the difficulty of beating the market can be partly attributed to market prices already reflecting current news. This broker apparently doesn't grasp the irrelevance of this hypothesis. What is relevant is the following:

Stock market returns minus costs equals investor returns.

The average investor pays professionals about two percent in fees. So no matter what the market does, the average investor will underperform the market by about two percent. This is as inescapable a fact as, say, gravity or the sun rising in the east. It doesn't actually matter how efficient the stock market is or isn't, or what direction it's going at any given moment.

The time for active management can only be now if "now" is when simple arithmetic stops working.

Strike Three: Arguing against his firm's founder

Maybe I'm giving away a bit too much here, but there is a bit of a contradiction between what this broker says and what the founder of Global Investments has said. Its founder has a long history of stating that the vast majority of his own equities were in low cost index funds, very similar to the ones this broker scoffs at.

As in baseball and the criminal justice system, three strikes and you're out.

My advice

Talk is cheap. The next time you hear about the great debate between active and passive investing, think about the absurdity of what is actually being "debated." Keeping in mind the ever-so-simple rules of arithmetic, is it even possible that the 90 percent of the market that is professionally managed can all be above average? Mathematically speaking, only 50 percent will be above average, before fees; and less than one percent will beat the market, after fees, in the long run. This debate is only held open by the billions of dollars Wall Street pours into the propaganda to muddle investors' understanding of this simple equation.

When any financial professional makes claims, get them to back them up with data. If they don't, won't, or can't, do you really want them managing your nest egg?

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