Actively Passive?

he issue of active vs. passive management often arises when describing how individual equity funds are managed. Index funds are typically defined as "passive" portfolios while funds with more active intervention by a manager or team of managers are described as "actively" managed. The terms "passive" and "active" are vague, and therefore problematic, but I will pass on that particular issue at this time.

Generally speaking, turnover ratio is a characteristic which distinguishes index (or passive) equity funds from actively managed equity funds. Typically, turnover ratio is higher among actively managed funds. For instance, the average annual turnover ratio for 2,073 distinct U.S. equity (non-index) funds with at least 5 years of performance data as of June 30, 2003 was 101%. For the 89 index funds meeting the same criteria the average turnover ratio was 20%. (Six ProFunds index funds were omitted due to their unusually high turnover ratios which radically skewed the results).

While the active vs. passive issue is certainly germane to the turnover ratio of individual funds, the active/passive dichotomy must be extended to the issue of how equity funds themselves are managed within an account.

Active account management suggests frequent portfolio reviews possibly leading to changes in the funds utilized in the portfolio. Passive account management would engage in portfolio reviews less often, and thus would be more of a "buy-and-hold" approach. Figure 1 illustrates the four quadrants of what I will simply refer to as the "Active/Passive Grid".

This article explores two boxes in the Active/Passive Grid (both in the Index Funds column), namely Index/Passive (brown box) and Index/Active (blue box). Studying active and passive account management using actively managed funds (green box and pink box) at a macro level is virtually impossible due to an enormous number of possible combinations of active funds. Index funds which attempt to replicate the return of prominent equity indexes are much fewer in number and thus more feasibly analyzed.

Four index funds were utilized for this study: Vanguard 500 Index, Vanguard European Stock Index, Vanguard Small Cap Index, and Vanguard Total Bond Index. Annual return data were obtained from Morningstar's Principia software.

The first option - Index / Passive (brown box in Figure 1) - was simulated by investing $1 into each of the four Vanguard Funds at the start of 1991 and continuing through the end of 2002, a period of 12 years. This was a buy-and-hold approach. By the end of 2002 the aggregate average annual total return of this approach was 9.6% (see Figure 2). The annual standard deviation of return for the buy-and-hold approach was 15.3%. This approach did not employ annual rebalancing.

Figure 1. The Active/Passive Grid

The Index / Active approach (blue box in Figure 1) was simulated in two different ways using the same four index funds. The first approach is referred to as "Best Fund Next Year" and involves a 100% commitment to whichever fund had the highest return in the prior year. Thus, in 1991, the portfolio was invested entirely in Vanguard Total Bond Index (based upon the fact that it had the highest return among these four funds in 1990). In 1992 the portfolio was invested entirely in Vanguard Small Cap Stock (as noted by the lavender box) because it had the highest return in 1991. This pattern was repeated through the end of 2002. Interestingly, each fund was utilized three times during the 12 year period.

This "buy-and-trade" approach is based upon the notion that performance has/creates momentum going forward. The results offer some support for such an idea. The average annualized return of this type of buy-and-trade approach over this 12 year period was 15.5%, or nearly 600 basis points higher than a buy-and-hold approach. While this particular approach may appear much riskier than a diversified four fund approach (buy-and-hold), its standard deviation of return of 10.5% was 480 basis points lower. Understandably, this approach feels more aggressive due to the fact that it does not maintain a diversified portfolio from year to year as does the buy-and-hold approach.

The buy-and-trade approach (blue box) clearly creates the potential for tax liability as portfolios are radically rotated from year to year. For this reason, these results (along with the buy-and-hold results) are valid only under the assumption that the funds are held in a tax-sheltered environment such as a tax-deferred annuity account (401k, 403b, etc.).

The second Index / Active option was a blending of the first two approaches. At the start of each year 40% of the portfolio was allocated to the fund with the best performance during the prior year (as noted by the yellow box in Figure 2). The remaining three funds received a 20% allocation of the portfolio. After each year the funds were rebalanced to a 40/20/20/20 allocation. This approach generated a 12 year average annual return of 11.0% and standard deviation of 12.0%, both improvements over a buy-and-hold approach but a significantly lower return (and a higher standard deviation of return) than the more aggressive 100% "Best Fund Next Year" approach.

This study does not advocate a one fund portfolio. However, the results of such an approach are provocative, particularly when a one fund portfolio (i.e. 100% Best Fund Next Year) out-performed the other two approaches so dramatically with substantially less volatility of annual return.

More important than the results of these simulations is an appreciation of the logic which should govern both the selection of funds (using active and/or passive funds) and how the funds are subsequently managed - either "actively" or "passively". Recognizing that active vs. passive is (at least) a two dimensional issue is the real point here.

Figure 2. 12 Year Simulations

					Annual Return
	1991	1992	1993	1994	1995	1996	1997	1998	1999	2000	2001	2002	12 Year Average Annual Return	Standard Deviation of Return
Buy & Hold													9.6%	15.3%
Vanguard 500 Index	30.22	7.42	9.89	1.18	37.45	22.88	33.19	28.62	21.07	-9.06	-12.02	-22.15	10.7%	19.6%
Vanguard Europe Stock Index	12.40	-3.32	29.13	1.88	22.28	21.25	24.23	28.86	16.66	-8.21	-20.31	-17.95	7.5%	17.9%
Vanguard Small Cap Index	45.26	18.20	18.70	-0.51	28.74	18.12	24.59	-2.61	23.13	-2.67	3.10	-20.02	11.5%	17.8%
Vanguard Total Bond Index	15.25	7.14	9.68	-2.65	18.18	3.58	9.44	8.58	-0.76	11.39	8.43	8.26	7.9%	5.9%
100% Best Fund Next Year	15.25	18.2	18.7	1.88	22.28	22.88	33.19	28.62	16.66	-2.67	8.43	8.26	15.5%	10.5%
Vanguard 500 Index	30.22	7.42	9.89	1.18	37.45	22.88	33.19	28.62	21.07	-9.06	-12.02	-22.15
Vanguard Europe Stock Index	12.4	-3.32	29.13	1.88	22.28	21.25	24.23	28.86	16.66	-8.21	-20.31	-17.95
Vanguard Small Cap Index	45.26	18.2	18.7	-0.51	28.74	18.12	24.59	-2.61	23.13	-2.67	3.1	-20.02
Vanguard Total Bond Index	15.25	7.14	9.68	-2.65	18.18	3.58	9.44	8.58	-0.76	11.39	8.43	8.26
40% in BEST FUND 20% in others	23.68	9.53	17.22	0.36	25.79	17.74	24.93	18.41	15.35	-2.24	-2.47	-8.72	11.0%	12.0%
Vanguard 500 Index	6.04	1.48	1.98	0.24	7.49	9.15	13.28	11.45	4.21	-1.81	-2.40	-4.43
Vanguard Europe Stock Index	2.48	-0.66	5.83	0.75	8.91	4.25	4.85	5.77	6.66	-1.64	-4.06	-3.59
Vanguard Small Cap Index	9.05	7.28	7.48	-0.10	5.75	3.62	4.92	-0.52	4.63	-1.07	0.62	-4.00
Vanguard Total Bond Index	6.10	1.43	1.94	-0.53	3.64	0.72	1.89	1.72	-0.15	2.28	3.37	3.30

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Craig L. Israelsen is an Associate Professor in the Department of Consumer and Family Economics at the University of Missouri-Columbia (http://www.missouri.edu/index.cfm) where he teaches courses in Personal Finance and Family Living. He holds a Ph.D. in Family Resource Management from Brigham Young University. He received a B.S. in Agribusiness and a M.S. in Agricultural Economics from Utah State University. Primary among his research interests is the analysis of mutual funds. He writes monthly for Financial Planning magazine.