illustration of world equity indices

Much like the previous boom in technology stocks, today’s tech darlings – the so-called “FAANG stocks” (Facebook Inc., Apple Inc., Inc., Netflix Inc. and Alphabet Inc. [a.k.a. Google]) – have accounted for a disproportionate amount of global stock market returns. As in the late 1990s, index investing is garnering a strong and growing following, prompting more clients to ask about it. Financial advisors who choose active portfolio management must do so based on a clear, supportable rationale.

But much of the investment industry’s argument focuses on myths while missing the bigger picture of advisors’ true value:

Myth 1: net returns matter, not fees

The success of indexing hinges on low costs. However, many retail advisors state that the focus should be on returns – not costs – as they can find skilled portfolio managers. Practically speaking, the data don’t support this.

Gross of costs, portfolio managers who use active management generally have demonstrated skill. But a strong majority of retail investment products underperform broader markets net of retail costs. In other words, the skill exists, but it gets diluted by higher retail fees.

There’s a limit to what you should be willing to pay for skilled active management. Being proactive in controlling costs – which fiduciaries do for their clients – helps tilt the odds in clients’ favour. This can be accomplished through the creation of an institutionally priced investment platform, thereby increasing the odds of active management success.

Myth 2: index funds offer no downside protection

There’s some truth to this, but active portfolio management’s downside protection is attributed largely to cash balances, which are driven by cash flow, not by active decisions. Downside protection on a total portfolio basis comes from smart asset allocation based on future spending goals and sensible rebalancing.

Some investment strategies can keep up with broader markets in good times with meaningfully less downside and volatility. But finding those investments truly requires rigorous due diligence to understand the source of returns in up-and-down markets.

Myth 3: we’re entering a stock-picker’s market

Some people pull out this argument when expecting a “sideways” market – i.e., deep swings up and down with little to no return over a period of time. I have examined past decades during which U.S. stock returns ranged from small negative to small positive annualized returns. My comments on Myth 1 ring true.

Gross of fees, such periods have seen a high percentage of active management outperformance. But net of retail product fees, this outperformance almost disappeared entirely. Skilled money managers have benefited from stock-pickers’ markets. But investors paying standard retail fees unfortunately did not enjoy the benefits. Again, an institutional platform combats these challenges rather effectively.

Disciplined do-it-yourself investors can pocket significant fee savings from traditional index investing. But only a tiny percentage of investors (about 1%) are sufficiently disciplined to realize these cost savings. For the other 99%, the true value of professional advice has little to do with the age-old active vs passive debate.

The vast majority of investors can benefit from qualified professional advice that integrates wealth planning with investment management. This includes a robust discovery process, goals-based planning and a portfolio designed around these important inputs. The value of this combination is so significant over time that it can render the active vs passive debate almost meaningless.IE

Dan Hallett, CFA, CFP, is vice president of Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.