Written by Krisna Patel, CFA, and edited by Hanna Jackson
Do you ever joke about the accuracy of weather forecasts? Honestly, I often dismiss any forecasts more than two days out and doubt that meteorologists can accurately predict anything beyond the next 24 hours. According to the National Oceanic and Atmospheric Administration, however, weather forecasts are accurate 90% of the time in a five-day forecast and a surprising 80% in a seven-day forecast[i]. Many of us may question this statistic because we naturally recall when the forecast was wrong, not when it was correct. This misperception stems from a notion called the availability bias. To make decisions as rapidly as possible, our brains take “mental shortcuts” by recalling the most readily available memories that led to the desired outcome. In the case of the weather, we typically recall the times our plans were changed or ruined due to forecast inaccuracies. As a result, we tend to largely mistrust those forecasts.
Active funds are not a one-man show. Management firms combine supercomputing capabilities with a multitude of field experts who have earned credentials like PhDs, MBAs, and CFA charterholders. Theoretically, then, these investment powerhouses have every advantage to produce funds that outperform benchmarks like the S&P 500®, yet they fail on a consistent basis[i]. I believe there are five major reasons why large-cap managers in particular fall short of the S&P 500®.
It comes as no surprise that investors expect financial advisors to be able to select profitable and suitable investments for client portfolios. There are three primary ways in which advisors approach this decision-making process. Some advisors rely on their home office or investment companies to perform the research and create a list of recommended investments. Others prefer to leave the investment decisions and asset management solely in the hands of a third party. Lastly, an advisor may prefer to perform their own research and analysis to determine suitable investments for their clients.
As an advisor who enjoys the research and analysis approach, I have begun to wonder if the time spent on choosing between active and passive management, especially with large-cap blend funds, is worth the trouble. Many different studies are available to argue the success of one over the other, and each strategy certainly has its pros and cons. I do not intend to elaborate on these differences; instead, I am presenting data I have gathered over the years for advisors and investors to bear in mind when deciding between active and passive investments.