Today’s investing landscape is dramatically different than that of 25 years ago. One of the most significant differences is the huge shift in opinion related to the merits of passive investing (as practiced by index funds) relative to the benefits of traditional, actively managed mutual funds.

The academic support for passive strategies has greatly transformed the investing landscape. While index funds existed 25 years ago, their popularity (along wth ETFs, also passively managed) has soared in the years since.

Consider the way professional investing advice is now most commonly structured. Many brokers and advisers no longer compete based on who has the best performance, but sell their services based on helping with asset allocation and relying on index funds.

Passive management

Passive investing, commonly referred to as “indexing,” is a natural outgrowth of the Efficient Market Hypothesis (EMH), which argues that because of the collective efforts of the market’s millions of participants, all of the known information about a given security is already reflected in its price. As a result, market prices should be regarded as accurate estimates of an investment’s intrinsic value, such that it’s pointless to try to find inaccurately priced (i.e., undervalued) securities with the expectation of outperforming the overall market. (For a more detailed discussion of the EMH — and why SMI is skeptical of at least its strongest form — see our August 2012 cover article, Understanding Market Efficiency (And its Limitations).

If a person’s starting point is “it’s impossible to beat the market,” then the most sensible approach is to simply build a portfolio that essentially replicates the market, while paying the lowest possible fees to do so. In this view, there’s no point in taking active measures trying to beat a market that can’t be beaten, so a passive approach makes the most sense.

While SMI isn’t in the EMH camp, we’re not as far away from it as some may suspect. We would argue with the idea that it’s impossible to beat the market over time, but we readily admit it’s difficult to do so.

SMI’s oldest strategy, Just-the-Basics, is a pure indexing approach. We’ve long advocated that individuals who (perhaps due to restrictions on their investment choices in a particular account) can’t implement a specific, disciplined active strategy such as the ones SMI provides — or who won’t commit to sticking with such a strategy — are better off using an indexing approach rather than trying to select investments on their own.

Active management

Active managers believe that the market isn’t perfectly efficient, which leaves open the possibility of improving on the market’s overall result. The most common goal of active management is to earn returns that are better than a benchmark that represents a particular investment (the S&P 500, for example, often is used as a benchmark for “beating the market”).

In some cases, other goals are pursued by active managers. For example, an investment might attempt to earn the same return as the market, but with less volatility. Whatever the specific goal, the premise is that taking certain actions can provide a benefit compared to passive investing.

Passive vs active: who wins?

The debate over whether passive investing is fundamentally superior to active attempts to beat the market has become an ideological struggle for superiority, with big money riding on the outcome. Accordingly, a huge amount of academic research has been done on the passive vs. active subject. The vast majority of it finds in favor of passive investing. This isn’t surprising when one considers the big picture. Ultimately, the market’s total return is a fixed pie. For every investor that earns an above-market return, there must be another that earned a below-market return. The total has to balance out. This isn’t Lake Wobegon, where everyone is able to earn above-average returns.

That fixed pie of total investment returns is then going to be reduced by the expenses of various investment providers. That leaves investors — cumulatively — with returns that equal the market’s total return less the total expenses extracted. On average, then, investors’ returns are going to trail the market’s return due to these expenses.

Much of the research on passive vs. active investing focuses on this type of cumulative analysis. Looking at all the mutual funds in existence over an extended time period, for example, will invariably show that, in total, they lagged the market. It would be impossible for them not to.

But the relevant question for investors isn’t whether actively managed funds can outperform the market as a group. The answer to that is always going to be no. Rather, the real question is whether there’s a realistic way to identify specific individual active investment strategies that will outperform the market. That’s a very different issue than grouping all active investment attempts together.

Enter momentum

SMI offers a variety of actively managed strategies (e.g., Upgrading, Dynamic Asset Allocation, and Sector Rotation), but they are all based on the same investment principle — momentum. The definition of momentum as it relates to investing is simply the tendency of investment performance to persist. Investments that are performing well have a tendency to continue doing so, and vice versa.

Most investors are unaware that performance momentum has a long history of academic support. The earliest scientific study and published academic paper in support of momentum dates back nearly 80 years to 1937, and there have been many since, including a flurry of research done in recent decades.

One reason performance momentum has been so heavily studied in recent years is that it has been a persistent thorn in the side of the efficient-markets crowd. Remember, the EMH believes that a phenomenon like investing momentum should not exist. So when faced with a seeming contradiction to their theory, believers in the EMH have a strong incentive to explain away such anomalies. Yet in the case of momentum, no less an authority than Eugene Fama, often referred to as the father of the EMH, called momentum “the center stage anomaly of recent years…the premier anomaly is momentum.”

It’s important to qualify that the academic research is quite clear that momentum is a relatively short-term phenomenon. The research demonstrates that performance persists over periods of 12 months or less. This is why the old advice regarding how to select mutual funds is worthless: identifying funds with good long-term (3-, 5-, or 10-year) track records has no bearing on which funds are likely to perform well over the coming year. Longer-term performance simply is not predictive. But short-term performance has repeatedly been shown to be predictive. Again, these aren’t SMI claims, this is what numerous academic studies have concluded. (Links to several of these studies are available here.)

Recognizing that momentum is one of the few proven anomalies to the EMH, but that momentum is inherently a short-term phenomenon, requires us to continually monitor our investments for changes in momentum. Unlike indexers, we don’t have the luxury of buying a particular set of investments and holding them forever. The price of trying to outperform the market (and minimize the damage done by bear markets such as investors experienced in 2008) is that we have to stay engaged with our investments. This is why SMI’s active strategies include regular (usually monthly) “check-ups” where we determine if changes to our investment lineup are required.

Passive, active — or something better

Using momentum to select investments in an effort to beat the market is inherently an active-management approach. But we can apply it using passive (as well as actively managed) investment vehicles.

For example, in Dynamic Asset Allocation (DAA), we monitor and compare broad asset classes — U.S. stocks vs. bonds vs. real estate vs. gold, etc. The most efficient and least expensive way to get exposure to these broad asset classes is to use index funds (ETFs), which are passively managed vehicles. So in DAA, we’re using an active management technique to select passive investments.

In contrast, our Sector Rotation strategy relies almost exclusively on actively managed funds. Our Stock and Bond Upgrading strategies rely more on active funds than passive ones, but include both at times. The investment vehicles SMI uses vary between passive and active, but in all of the strategies (except our indexing Just-the-Basics), SMI uses an active technique to select those investments.

Over the long-term, these active strategies have provided returns well in excess of what the market has provided. In recent years, specifically since the 2008 financial crisis, indexing has had the upper hand over most active strategies. Although Sector Rotation has continued to far exceed the market’s rate of return, both Upgrading and DAA have trailed the market over the past 5 years. It’s not unusual for index funds to outperform during bull markets such as we’ve had in recent years, but that script often changes during bear markets. (See When Will the Clock Run Out on the Indexing Advantage?)

Our most recent research indicates that using momentum to select a blend of passive and active investment vehicles produces the best risk/reward outcomes. If you haven’t read our May 2014 cover article, Higher Returns With Less Risk: The Best Combinations of SMI’s Most Popular Strategies, we highly recommend that you do so. It makes a powerful argument by laying out the risk/reward framework and thought process behind combining multiple strategies within your portfolio.

Certain investing strategies respond better than others to specific economic conditions and threats. By combining multiple strategies within a single portfolio, an investor can obtain better diversification than is possible with a single approach. For some, this may be more than they want to manage themselves, which is why automated approaches are available for certain SMI strategies.

Conclusion

While “passive vs. active” has become an ideological struggle for many, SMI takes a more pragmatic view. We want to help SMI members earn the highest possible returns with the least possible risk. We are happy to use both passive and active vehicles and strategies to accomplish this goal.