Advisors Should Go Beyond the 'Easy' Button

Advisors increasingly consider indexing the “easy” button of investing. Index-oriented approaches are low-cost, tax-efficient and simple to implement. Advisors who adopt index-oriented approaches may also have fewer difficult conversations with clients about underperforming managers.

The attraction of the “easy” button is understandable; however, advisors should consider the merits of integrating high-value-added active strategies with a core of low-cost, tax-efficient index strategies.  

Index investments offer a compelling option in certain asset classes; actively managed investments may offer return or risk management advantages in other asset classes. Advisors seeking to combine passive and active investments should adopt an asset class-based framework.

Factors to consider include the probability, payoff and persistence of outperformance, as well as the quality of the index used for the asset class. 

The major factors can be defined as follows:

• Probability of outperformance: The percentage of funds in the asset class that outperformed the index over a market cycle is a good starting point. For example, only a small percentage of U.S. large capitalization funds have outperformed relative to the S&P 500 Index over the past five years and numerous other rolling five-year periods. Although the failure of active managers to beat the index in the U.S. large-company universe gets the most press, active managers have demonstrated a higher probability of success in other segments of the market. 
• Payoff from outperformance. Many advisors devote considerable effort to identifying the “best” manager in an asset class. The added investment cost and risk may not be worthwhile if “top performing” active managers in the asset class beat the index by a slim margin. The higher the return differential relative to the returns delivered by an index investment, the higher the potential payoff from active management. 
• Persistence of outperformance: Top-performing funds often fail to sustain their success, in many cases reverting to the mean or in the worst-case scenario going from the top to the bottom quartile. In many cases, winning strategies employ an investment style or follow a theme that goes from being in favor to being out of favor. One way to assess the persistence of outperformance is to review what percentage of top quartile managers in one market cycle stay in the top quartile for the subsequent market cycle. The higher the percentage of “repeat winners,” the higher the likelihood that advisors will be able to select a manager able to sustain performance success. 
• Quality of index: Some indexes are better than others at providing a transparent, liquid and inexpensive way to invest in an asset class. The Russell 1000 and S&P 500 indexes are good examples of indexes that meet those foundational requirements. Well-managed index funds can closely track the returns of either index. Not all indexes are as efficient as the Russell 1000 or S&P 500. Index performance in some asset classes may be influenced by the performance of less liquid index constituents, with hard-to-trade securities potentially making it more difficult for index funds to track index performance. Bond indexes may also present challenges, as in asset classes such as high yield, the biggest borrowers are the largest index constituents.  

Using this asset-class-based framework as a guide, index investments are a compelling option for U.S. large-cap stocks. Most actively managed U.S. large-cap funds have trailed their benchmark index over multiple market cycles, and when they do “win,” the payoff is rarely worth the incremental cost and tax impact. Persistence of performance has also been low among U.S. large-cap funds.