Our Take on the Active vs. Passive Debate
Hedge Funds, and most famously Warren Buffett of Berkshire Hathaway, typically write pieces referred to as their investors' "Owner Manuals", which outline their investment philosophy and set expectations for their investors. The following is the first of a few topics we will discuss that outline our investment philosophy and should be viewed similarly. Because we are not a hedge fund or publicly traded company, "Owner Manual" seems inappropriately titled - I think of this as the first part to our "User Manual" at Hylland Capital Management.
The Active vs. Passive Debate - Our Take at Hylland Capital Management
Lead by Vanguard (which now holds over $3 TRILLION in assets!), "Passive" and "Index" are the biggest buzz words in the investing world today. And it appears rightfully so - For decades the majority of "active" managers have under performed their "passive" index benchmarks.
Typically, active and passive managers are differentiated by whether they deviate their holdings from a defined index. Say I was a fund manager that invested solely in small companies. If I am "active" I will select a certain number of companies to invest in based on some criteria (growth, value, etc.), whereas if I am "passive" I choose to simply own all the small companies that exist under that same criteria, and not try to pick winners and losers.
An example of an active fund doing just this is the Vanguard's Explorer Fund. It picks about 700 companies out of the Russell 2000 Growth Index that it believes will perform the best.
A passive fund manager will simply buy every single stock in the Russell 2000 Growth index (There are about 1200.)
And study after study has shown that, on average, "active" investors have been bad at predicting which stocks will do well, and which will do poorly.
So now it may come to your surprise that at Hylland Capital Management we prefer to use individual stocks over index funds when possible for our clients. Why in 2016 would we start a new asset management business based on something that typically under performs?
In order to defend our investment style, it is important to understand the characteristics of passive investments that have made them successful and also their limitations.
I see passive and indexed based investing having 2 advantages that are beneficial for the typical investor. And we can utilize these advantages in a portfolio primarily consisted of individual stocks as well. Below is a list of benefits of passive index funds, and also a list of how our portfolios are constructed to take advantage of the characteristics that have made passive investing so popular.
1. Low Turnover of Assets
Low turnover means less selling of one stock and buying of another. Turnover creates all types of added expenses that come out of investors returns each year. Notably, higher commission costs for the funds, and higher short term capital gains.
Typically, a passive index fund has very low turnover, as they do not buy and sell frequently in attempt to pick winners and losers. This lower turnover of passively managed funds leads to less short term capital gains taxes, less commission charges, and less likelihood for adverse effects on performance from trading on emotion or panic. Typically, passive index funds have very low turnover because they are simply blindly following a benchmark. Take Vanguard's Russell 2000 growth ETF, which had a turnover of 34% last year and compare it to Vanguard's actively managed Explorer Fund which had a turnover ratio of 62%. What do these percentages mean? A turnover rate of 62% means that 62% of the fund's assets are sold during the year. Or in other words the average holding period for each security is less than 2 years!
All the additional buying and selling by Vanguard's Explorer fund leads to additional short term capital gains taxes (which depending on your income tax bracket is typically 10-20% higher than long term capital gains taxes!) , and increased commission costs.
These increased costs lead to smaller returns each year, and therefore less money able to compound year after year in your account. Warren Buffett discussed this effect in his 1989 letter to his shareholders of Berkshire Hathaway:
Because of the way the tax law works, the Rip Van Winkle style of investing that we favor – if successful – has an important mathematical edge over a more frenzied approach. Let’s look at an extreme comparison.Imagine that Berkshire had only $1, which we put in a security that doubled by yearend and was then sold. Imagine further that we used the after-tax proceeds to repeat this process in each of the next 19 years, scoring a double each time. At the end of the 20 years, the 34% capital gains tax that we would have paid on the profits from each sale would have delivered about $13,000 to the government and we would be left with about $25,250. Not bad.If, however, we made a single fantastic investment that itself doubled 20 times during the 20 years, our dollar would grow to $1,048,576. Were we then to cash out, we would pay a 34% tax of roughly $356,500 and be left with about $692,000.
Because of the enormous effects like Buffett noted above, it becomes obvious why index investing has become so popular. Too often it becomes nearly impossible for an active manager to overcome all of the increased costs associated with high turnover.
Here is a look at the last 2 years of distributions for Vanguard's Explorer Fund:
Over the last 2 years, investors in the Explorer Fund have had about $2.30 in short term capital gains per share.
And depending on your tax bracket, even the long term capital gains may present a hefty tax bill - Explorer Fund has distributed nearly $20 per share in long term capital gains over the past 2 years.
This represents over $22 per share of money that is subject to the tax treatment detailed by Buffett above - money that is unable to reap the rewards of compounding interest with tax deferral.
Low Turnover - What We Do at Hylland Capital Management
As long as we are not frequently buying and selling to try and time the market, our turnover can remain as low, if not lower than an index fund. That means less fees and taxes for you.
We take this idea of a "Rip Van Winkle" style of investing to heart and ideally, if we follow this style of investing we have a turnover approaching 0% for our client portfolios.
And now we get to see some discrepancies between the typical preconceived notions in the "active" vs. "passive" debate. Many would consider our style of investing to be "active" because we don't invest to simply follow an index, and yet it has a significantly lower turnover rate than a Vanguard "passive" index fund.
Because in fact, even indexes, commonly thought of as passive and isolated from investor emotion, are subject to the people who manage it. Each year, on average, 20 of the companies whose shares make up the S&P 500 are dropped, and 20 new companies added. Even this "trading" by those who manage the passive index has hurt performance over the long term, as cited by Jeremy Siegel and Jeremy Schwartz.
On top of this, all too often financial advisors or individual investors who claim themselves "passive" investors find themselves getting in and out of these index funds several times per year, creating the same effect as trading in and out of individual stocks.
Our focus is to generate long term capital appreciation for our clients. We make sure all clients understand what we mean by "long term" before going into business together. Because a typical 25 year old more than likely has over 5 decades of time to hold investments. As Buffett's example above shows, the compounded effects of low turnover over decades can really add up.
As I type this at the beginning of 2016, another quote from Buffett's 1996 letter seems especially applicable:
Our portfolio shows little change: We continue to make more money when snoring than when active.
Inactivity strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly-profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit had reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses? The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management.
2. Low Costs
Specifically, dealing with a fund's expense ratio.
Another huge difference between passive and active funds is found in their expense ratios - the fee that they charge investors every year to be invested in the fund. Expense Ratios are listed as a percentage (say 0.40%) and represent the percent of your investment that they charge each year.
So if you have $10,000 invested in a fund with an expense ratio of 0.40%, you will pay $40 per year ($10,000 x 0.40%).
Obviously, a manager who spends his day actively selecting stocks will demand a higher fee than someone who simply owns everything. So active funds typically have a higher expense ratio than a simple passive index fund.
Continuing with our 2 funds used as an example at the beginning of this post - Let's compare Vanguard's Explorer fund expense ratio vs Vanguard's Russell 2000 growth fund:
- Vanguard's Explorer Fund - 0.53% (which is actually pretty low for an active fund - the average is around 0.70% up to 1%. Vanguard says the average is 1.33% for funds that invest primarily in small companies!)
- Vanguards Russell 2000 Growth Fund - 0.20% (and many index funds expense ratios have dropped even lower - many around 0.10%)
So, not only do the managers of Vanguard's Explorer fund have a struggle just to match the performance of the index, they now must actually outperform it by 0.33% just to "break even" with the index.
And in addition to this, asset managers will charge you a fee on top of the expense ratio of the funds they invest you in. These fees are typical around 1% - 1.5% per year.
So, you are going to pay 1% - 1.5% per year to someone, who is just going to put you into funds that charge you upwards of 1.33%.
Of course we too charge a fee for our services at Hylland Capital Management (albeit, lower than average). However I feel part of my responsibility for charging that fee is capital allocation. If you are going to pay an Asset Manager up to 1.5% per year just to act as a middle man for your investments, I don't think you are getting good value on your 1.5%.
We do the capital allocation at Hylland Capital Management - We don't outsource it to other fund managers or robo-advisors. So in essence I believe that our AUM fee at Hylland Capital Management should be thought of as including the fees you would receive from typical funds' expense ratios along with a typical asset manager's fees.
It is up to me to provide value in that fee and of course, and it is your job to decide if I do a good enough job to justify that fee!
So let's take a look at how all these fees can add up :
Many of our clients probably saw this calculator at least once in one of our presentations. We can input any number for AUM fees, expense ratios, investment amounts and growth percentage. But for sake of argument lets consider a hypothetical investment of $10,000 per year with $5,000 added annually that grows at 6%. We take into account our typical fees on the right hand side (noted in blue) and compared to a "middle man" asset manager I described above on the left (in the black). The chart represents the final total value of the portfolio after 30 years of compounding at 6%.
What we see is that fees really add up over time! IF we can achieve returns similar to other asset managers that charge higher fees and invest clients in funds with higher fees, we can create significant value for our clients over time.
So although our "active" investment style has associated costs, we believe that if we could keep these costs to a minimum - we have a chance to create long term capital appreciation for our clients compared with clients of other asset management companies.
Low Costs - What We Do At Hylland Capital Management
So how do we keep costs low? Besides our lower than average AUM fee, our "active" style can also be a benefit to our clients.
A portfolio of individually held stocks has no expense ratio, unlike any fund (active or passive). Theoretically we can buy the same stocks that are in, for example, Vanguard's Russell 2000 Growth index fund and save the 0.20% expense ratio each year.
A huge reason we hold our client account at Folio investing is because they do not charge commission for each stock trade. Whether we buy 1 stock or 100, our fee to them remains the same with their innovative "window trading" system. Basically - if we set our trades to execute at a specific time during the day they are commission free.
So now, our "active" investment style of holding individual stocks actually carries lower costs than if we were to invest our clients' money in passive index funds.
We aim to keep our clients out of funds as much as possible in order to avoid these expense ratios. However, currently it is not practicable for certain areas - For example, emerging market stocks. Here our clients will find that we utilize low cost ETFs. For this reason, I put 0.10% in the "Avg. Expense Ratio" block in the image above - but really it should be much lower - as we will see below.
Our clients will periodically see us mention their "Account-Weighted" Average Expense Ratio, which is calculated based on the expense ratios they do pay and their total account value.
As an example, consider a portfolio of $100,000 with:
- $80,000 in individual stocks.
- $10,000 in an emerging market equity fund with an expense ratio of 0.2%.
- $10,000 in a U.S. treasury bond fund with expense ratio of 0.1%.
And we do a weighted average calculation:
And would find for this situation, this hypothetical portfolio pays an account-weighted average expense ratio of 0.03% - lower than any fund you will find today, passive or not.
So, although many would describe our investment style as "active" we find we can keep fees lower than if we simply blindly dumped client money into funds, even "low-cost" passive index ones.
Conclusion - Our Take on the Active vs. Passive Debate
Index investing has been incredibly successful for the average investor, and will continue to be so. However, like many "front page" stories - the story has been transformed into something different than it was when it started. Now, the story line has turned to discredit any form of investing that does not involve passive index funds.
It turns out, it is not as cut and dry as some would like you to believe.
As index investing has grown in popularity, investors have begun to forget WHY passive investment styles have been so beneficial.
Simply investing in index funds does not change anything if you do not have the discipline and patience to let the benefits of low costs work their magic. Many investors (and asset managers!) today are quick to brag about their passive index fund holdings, which really mean nothing if they frequently shift from one passive index fund to the other.
We also find today that investors have taken the gospel of passive investing to an extreme. An investor who buys and holds a handful of stocks for 2 decades is much less "active" than an investor who invests solely in passive index funds - and yet one investor will go out of his way to call himself a "passive" investor over the other.
It is primarily because of a passive funds' low fees and low turnover that they have seen better performance. And we believe that we can create portfolios that contains those same characteristics for our clients in order to help them achieve their financial goals.