March 2020 - Over the past 10 years, passive investing has been a successful investment strategy. A $10,000 investment in an S&P 500 index fund on January 1, 2010 would have been worth $35,666 on December 31, 2019. That equates to an annualized return of 13.56%, far exceeding the index’s long-run historical return of approximately 10.00%. Clearly, capturing 100% of the market’s upside during this long, bull market run has worked out well for investors. Why worry about downside risk, when passive investing generates these types of returns? Why look to active management, when only a small handful of managers can outperform in this environment and are usually taking excessive risk? These are valid questions. In the strong bull market over the last decade, even novice investors who simply look to mirror the market, have outperformed some of the best active money managers in the industry.
While it is true that passive investing has generated superior returns relative to active management during this time period, there is a reality that exists that many investors choose to ignore. Yes, indexing in a bull market allows for full participation in the upside, but this comes at a price. Investors will also feel 100% of the downside during any correction or bear market, as passive investment has no downside protection. You get 100% of the upside, but you also get 100% of the downside. Gains that have been achieved during years with strong returns, like 2019 when the S&P 500 had a more than 30% return, can be completely erased during a market downturn, like in 2008 when the S&P 500 had a -37% return. Investor memories may be short, but it is important to consider investment horizon and long-term, risk-adjusted returns as part of an investment strategy.
While many investors believe they can simply move to cash in a downturn, it is incredibly challenging to time equity markets with any precision. Getting this timing incorrect, either by missing out on a big up year or exiting near a cycle bottom can be devastating to an investor’s long-term objectives.
So what is the solution? One approach to mitigating the risks associated with an all-passive approach to investing is to employ a strategy that focuses on protecting assets during the inevitable market downturn. In other words, focus on investing in companies that can do well during periods of economic growth, but also keep an eye on how such companies perform during downturns. This can be done on a company-by-company basis or at the portfolio level. By doing so, we believe long-term outperformance can be achieved without fully participating in 100% of the upside during bull markets, but by protecting capital during downturns. Such portfolios have the added benefit of not having to worry about timing or when “the top is in” since no one can know this with any degree of certainty.
As an example, let’s look at the last full market cycle of the S&P 500 from 2003-2008. Coming out of the dot-com implosion, the index experienced five consecutive years of growth. This was followed by the subprime crisis of 2008, when the index endured a -37% return. Employing a passive-only strategy during this period would have resulted in an annualized return of 2.36%. If an investor elected to invest in a less volatile strategy in which they capture 80% of the upside, but only 50% of the downside, they would have experienced an annualized return of approximately 4.87%. Trying to time the markets during this period could have had a significant impact as well. If an investor got into the market in 2004, missing the strong performance in 2003 in which the S&P 500 returned 28.68%, they would have had a 1.55% annualized return if utilizing the 80/50 strategy. The passive-only investor’s returns would have been negative at -2.09% annualized. The obvious question becomes where to find a manager who can achieve this result of participating in up markets but preserve capital during downturns. This combination is best found through active management. A manager must look for ways to construct a portfolio that has growth attributes but differs sufficiently enough from the benchmark and carries less volatility. This is typically done through a combination of stock selection and sector allocation. At AMI Asset Management, we’ve been able to achieve a risk/return profile that fits this criterion. Since the strategy’s inception of 1/1/1998, AMI’s Large Cap Growth strategy has had a downside capture ratio of 53.06% versus the Russell 1000 Growth, while also achieving an upside capture ratio of 82.90%. This has been achieved by constructing a concentrated portfolio that strives to maintain a lower standard deviation than the benchmark but one that also has sufficient earnings growth to drive stock appreciation. Through our philosophy of investing in companies with recurring revenue business models, those which have products and services consumed in less than two years and are less volatile by nature, and overweighting defensive sector such as consumer staples and healthcare, our strategy has been able to outperform the S&P 500 on a gross annualized basis since its inception (11.06% vs. 7.63%). During certain periods our strategy has performed better or worse than the benchmark, but by employing it over the entire market cycle, our historical performance shows the benefits of lower upside capture coupled with lower downside capture. This approach is in contrast to many other large cap growth strategies which have potentially increased risk by being overweight more cyclical areas and investing in momentum-driven stocks in order to beat their benchmark. While such a strategy may work in the short term, there are significant short- and long-term risks to which many investors may be unaware.
There is certainly a place for passive-only investing in today’s environment. If the market continues to rise, it is possible that these types of strategies will continue to outperform actively managed funds. However, as we’ve illustrated, this approach may expose an investor to significant downside risk. By pairing a lower standard deviation strategy such as AMI Large Cap Growth Equity, with a passive or aggressively active strategy, volatility can be reduced. Given how long this bull market has run, taking a proactive approach by adding lower volatility active managers who monitor downside protection, may be prudent.