The Best of Both Worlds

By: Shrey Patel

Chief Portfolio Manager, The Milwaukee Company

There’s an ongoing debate on Wall Street between active and passive investors: Which approach is most likely to generate superior returns consistently?

• Passive investors are content to capture market performance (referred to as “beta”).  This style of investing typically involves investing in ETFs that track broad market indexes such as the S&P 500.  The idea is that, by-in-large, Mr. Market (a euphemism for the market as a whole) makes better decisions than the individuals themselves who comprise the market.

• Active investing is a hands-on investment approach that seeks to generate “alpha” (that is, generate superior returns to the market, as measured by a comparable market index) by trading stocks.  Ideally, decisions on what to buy and what to sell are supported by extensive research and in-depth analysis of companies whose stocks are being traded (although that’s not always the case, as the WallStreetBets movement has so clearly demonstrated).

The popularity of passive investing has been accelerating for the last couple of decades as the number of ultra-low-cost index ETFs proliferates and the evidence mounts that the odds are slim for outperforming Mr. Market.  That’s especially true when the higher trading costs and taxes associated with active management are considered.

Take, for example, the following chart that compares the performance of Fidelity’s actively managed Large Cap Stock Fund with its underlying benchmark, the S&P 500 Index.

The active fund trailed its passive benchmark for the vast majority of the test period.  Adding tax implications would further deteriorate the active fund’s performance, making a strong case in favor of Mr. Market.

All that may sound encouraging for fans of passive investing.  However, it is critical to keep in mind that blindly following Mr. Market comes with its own set of perils.  That’s because, by definition, passive investing does not seek to actively manage risk.  This inattention to risk can be especially hard on investors with short time horizons and/or a low tolerance for market volatility.

For some folks, the likelihood of occasional deep declines can be a deal-breaker for adhering to a true passive investing strategy.  As an illustration, the chart below compares S&P 500 drawdowns[1] (red line) with a passively managed 60% stock/40% bond portfolio (blue line).

As we can see, a passive investment in the S&P 500 would have suffered drawdowns as deep as 50%, while a traditional 60/40 (equity/bond) portfolio would have cut the deepest peak-to-trough decline to a 30% haircut.  Such large drawdowns introduce “behavioral risk”, that is, ill-advised decisions due to periodic bursts of market volatility.

What if instead of beating Mr. Market, we invest in market beta for the vast majority of times and turn to safer assets when market volatility is expected to be high?   That’s the objective of The Milwaukee Company’s Smart Market Beta Strategy (SMB).

The approach adopted by SMB is different than pure active or passive styles of investing as it does not seek to outperform Mr. Market, nor does it invest with a buy-and-hold philosophy.   Instead, it actively seeks to lessen risk during periods of high market volatility, but otherwise sides with Mr. Market.  In other words, SMB attempts to combine the best aspects of passive and active investing in a single strategy.

To do so, SMB utilizes a set of proprietary indicators developed by The Milwaukee Company in an effort to identify the degree of risk prevailing in the equity and bond markets.   More specifically, equity risk is evaluated using price trends and return volatility, while bond market risk is estimated using the 10-year Treasury yield trends and fair- value estimates of current yields.  

When risk levels are considered to be “acceptable”, SMB will hold a market beta portfolio consisting of broad market index funds (ETFs) that, in the aggregate, represent the entire stock and bond markets, with an emphasis on U.S. securities.  More specifically, 60% of the market beta portfolio will be allocated to stocks and 40% to bonds.  

If risk appears to be high, the strategy will take a conservative approach by lessening exposure to securities that are most vulnerable to the risk at hand.

The following is a snapshot of SMB’s performance relative to actively and passively managed balanced funds.

In short, incorporating risk management into a passive investment approach has the potential to capture most, if not all, of the return associated with a market beta portfolio while providing investors with a smoother road to travel.  That’s a critical distinction because the odds are considerably higher for meeting long-term investment objectives when the behavioral risks are kept in check.

[1] A drawdown is a peak-to-trough decline during a specific period for an investment.