Does active management work? It’s easy to find arguments against it, whether from John Bogle, of Vanguard fame, or other market observers maintaining that (a) it is impossible to actively manage a portfolio and (b) the best investment approach is to buy and hold index funds for the long run. But before you accept the buy-and-hold arguments, there are other factors to consider.

It is possible by cherry-picking time frames or benchmarks, and disregarding the goals of a strategy, to prove that virtually any investment approach can fail investors at one time or another. But, in the end, it is pretty meaningless. Whether a strategy works or not comes down to the goal of the investment program, its benchmark, and the time period considered.

Fallacy of evaluating investments on a standard benchmark

For example, one successful active manager maintains a very simple benchmark—U.S. Treasurys—with the goal of outperforming an investment in U.S. Treasury bills while maintaining a comparable risk level. In reality, he has done considerably better than his benchmark and his clients have been delighted. Their portfolios have not outperformed the S&P 500 Index in rising markets, but they also have never experienced a down year. That made a big difference in the decade from 2000 through 2009.

Would it make sense to compare his performance to the S&P 500 Index and declare it doesn’t work because of the years when it underperformed the index? Simply, no. Yet, this is often the way active management is evaluated by others.

Some active managers have set as their goal providing investment returns competitive to a balanced 60/40 portfolio, with 50% of the volatility of the unmanaged equity index. If the manager meets the strategy’s goals but does not outperform an unmanaged market index such as the S&P 500, it does not mean the active approach failed. Reducing portfolio risk has a cost. The cost may be the loss of opportunity by investing a portion of the portfolio in lower-risk/lower-return assets, hedging costs, trading costs, and so forth. But staying fully invested can have an even greater cost if the market turns against a position.

Investing through a full market cycle

Other firms with more aggressive performance goals stress the need to evaluate investment programs over a full market cycle. Behind this requirement is the realization that management fees create a drag on performance during rising markets. But by reducing risk, such as minimizing losses in down markets, active management has the potential to more than offset management costs and produce less volatile returns for the investor.

Quantitative investment approach over emotional

Another successful active investment manager invests only in growth stocks with the goal of hitting home runs. If the rationale behind an investment continues to be valid, he holds it through down markets, although he is quick to sell if the company fails to meet performance expectations. There have been times when a home run took years to materialize. Did that make his approach a failure? Not when it made millionaires of his investors.

Compounding annual returns really makes a difference

Another factor to consider when judging the effectiveness of an investment approach is how performance is calculated. A major advantage of many active investment approaches is risk management. Effective risk management reduces losses when the market moves downward, preserving capital and providing the portfolio with an advantage over a buy-and-hold approach when the market turns back up.

When average annual returns are used to compare performance, the benefit of preserving capital is lost. For example, a portfolio that earns 6% annually for five years will outperform a portfolio with annual gains of +15%, +10%, +20%, +18%, and -30%, even though the second portfolio has a higher average annual return. The reason? It doesn’t take a 30% gain to recover from a 30% los; it takes a 43% gain.

So, does it work?

Active management works for many investors because it provides an approach they can stick with over the long run. Active management offers a logic for buying and selling and risk parameters that give investors some control over their fate. Yes, there is a cost when the sun is out and indexes are soaring with no end in sight, but active management provides protection in the other times.

Evaluating the success of an active management program has to start with the objective of the strategy and the appropriate “benchmark.” A benchmark gives the investor a way to evaluate whether the approach is working throughout the investment period and provides a measurement to manage investor expectations.

The benchmark may be a targeted annual return, an index or blend of indexes, or sometimes the manager’s own index calculation. Some active managers prefer not to use a benchmark at all, but rather a range of expected outcomes along a probability curve.

If a strategy is continually underperforming its specific objectives, there is reason to question its effectiveness. But underperformance comparing unrelated indexes gets into apples-to-oranges comparisons—something the media and many market commentators may excel at but is not very useful for advisors and their clients.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.