February's market spook served as a reminder of the importance of good active managers.

The end of active management is nigh. At least that’s the word on the street, if not The Street. Apparently, the rise of low-cost ETFs means those in my profession are not long for this world.

But I’m not buying it. Perhaps I’m just raging against the dying of the light, but the more I think about it, the more I believe there is going to be a place for good active investors for a while yet.

Never mind that giant sucking sound

When I look at where investors are putting their money, you could call me delusional. According to Morningstar, there has been a steady transfer of money from actively managed funds to passive instruments like ETFs over the past 10 years or so.

Last year, of the $684.6 million that flowed into active and passive funds for equities, bonds, and commodities, $691.6 million went into passive funds.

You read that correctly. More than 100% of the new money people invested last year went to passive instruments. Which means, of course, active funds reported net outflows.

Not looking good for our intrepid hero, is it? So why am I so calm?

Cleaning out the closet(ers)

First, because I think the investment industry needs a shake-up.

There are still far too many funds charging investors too much for sub-par performance. Many of these are closet indexers – funds that say they’re actively managed, and charge fees as if they are, but that hold portfolios that look suspiciously like their benchmark.

So I think a lot of investors can get better results by switching to low-cost index funds and ETFs. For a large portion of most people’s portfolios, those are perfectly reasonable solutions.

However, I don’t believe we’re talking about an all-or-nothing proposition. In my admittedly self-interested view, even in a world where many investors are turning to low-cost, passive options, there is still room for managers that earn their fees and deliver returns that beat their benchmark. The pool of money available to active managers may become smaller than it is today, but I think it will still be sizeable, particularly if the high-cost closet-indexing dead wood gets trimmed.

Managers with strong stock-picking processes and the discipline to stick to those processes should be able to generate superior long-term returns for their shareholders, and their work should ensure their continued existence and success. (For transparency’s sake, yes, I include your team at Motley Fool Asset Management squarely in this group.)

The fine print is just fine, I’m sure

Second, a recent Wall Street Journal article, alluringly titled “The Growing Peril of Index Funds: Too Much Tech,” reminded me that most people investing in index funds don’t pay that much attention to what they’re buying.

That’s pretty much the appeal of passive investing: You put your money in, and it does whatever the market does – and for the past nine years, that has meant it pretty much just goes up. No research needed. No regrets that you’re underperforming. People like easy and regret-free.

But this hands-off approach often leads to people who don’t fully understand what they’re buying. I’m not talking about anything as dramatic as what we witnessed with the rapid demise of the VelocityShares Daily Inverse VIX Short-Term ETN, which dropped 80% one day and will now be liquidated. Rather, I’m sure that most people buying the SPDR S&P 500 ETF (SPY), iShares Core S&P 500 ETF (IVV), or Vanguard S&P 500 ETF (VOO) don’t realize that the top 10 holdings – 2% of the number of companies in the index —represent 20% of the value of the index, or that nearly one-quarter of the index is exposed to tech stocks. (For thoughts on why this latter condition isn’t a big deal, check out this article by my colleague Tony Arsta.)

And most probably don’t care. For now.

Hey, I’ve got legs

“If you’re flammable and have legs, you are never blocking the fire exit.”
 – Mitch Hedberg

But what happens if the market stops just going up?

We got a taste of that situation between Jan. 29 and Feb. 8, when the U.S. market dropped 10%. I suggest, not coincidentally, that the period from Jan. 31 to Feb. 7 saw $34 billion pulled out of U.S. equity funds – the largest amount of money ever in a single week, according to industry reporting firm EPFR.

What happens if we’re not done seeing down days? Does it become more important to know what you’re invested in?

Does it become more important to know that the so-called FAANG stocks (Facebook, Apple, Amazon, Netflix, and Alphabet — a.k.a. Google) have returned an average of nearly 50% in 2017 and that these five stocks make up 11% of your S&P 500 index-tracking portfolio?

Maybe not, but if we do see a serious market correction and more investors feel an immediate need for cash, I’d wager these five stocks will be high on the list for consideration for profit-taking to cover cash outflows from actively managed funds, which still have more heft than passive funds.

This, combined with the knee-jerk exit reaction we saw demonstrated in early February, could have an outsize impact on index-based investors as some of the largest holdings in their index catch a double whammy.

Not for nothin’

I’m not a fortune teller, and I am not suggesting the sell-off in late January and early February was an omen of market carnage to come.

I am saying that passiveness sounds great when it means you win, but few people like to sit idly by while they rack up losses, even if they’re paying next to nothing to do it.

I’m also saying that active management has a better chance to flex its muscles in a market that isn’t moving up and to the right every day. In a more volatile market, stock selection rather than mechanical mimicry of an index can shine.

One of the benefits a trusted, disciplined management team has is the ability to deploy capital when less disciplined investors are running for the exits.

Of course, the major qualifier there is having a trusted management team. Your investors must believe in you – or at least agree with your process – enough to ignore the screams of the fleeing masses. It is hard to take advantage of market opportunities when all your funds are also flowing out the door.

And this is what gives me confidence in the continued relevance of your Motley Fool Asset Management team. I believe we’ve got a great process, including the pursuit of continual improvement.

More importantly, however, we’ve got a shareholder base that understands that markets don’t just go up, and that down days can stretch into painfully long episodes. They understand that, despite the queasiness in your stomach, that is the environment in which you can buy the great companies you’ve always wanted to own – and want to own for always – at attractive prices. That is when you lay the groundwork for superior long-term returns.

Latest Insights