On Saturday, my free weekly copy of Proactive Advisor Magazine showed up in my email inbox, as well as a special “Proactive Advisor Spotlight” email that focused on the active versus passive management debate. The Spotlight email contained three short articles by a researcher, a member of an investment performance database and publishing firm, and a behavioral finance professor. All concluded that active management should coexist with passive management, but for different reasons.

The professor’s article contained a number of arguments in favor of actively managed accounts that are rarely heard. While I invite you to read the entire article, I’d like to focus on his thoughts having to do with the instrument most often cited in connection with implementing passive investing, the index fund.

I think most of his behavioral arguments go back to a simple principle that he stated at the beginning of the article: “even investors with the right intentions stray from a strict adherence to an index fund, thereby negating its hypothetical long-term benefit.”

This is a function of human behavior. As I have often pointed out, S&P 500 Index funds are not made for investor mind-sets. Most investors will not sit still in an investment that loses more than 50%.

And if they do stay in and it returns to breakeven, they are more likely to sell on achieving that event than they are to hold on. But let’s say they do hold on at the urging of their advisors. Will they do it again if it falls 50% all over again?

Yet that back-to-back 50%-loss scenario is exactly what the S&P 500 Index, and the funds and ETFs that track it, did in the decade from 2000 to 2010. In this sense, too, it is easier to understand why the investors who abandoned stocks in the first decade of the millennium have failed to return.

And that’s why the professor contends that the results cited for the S&P 500 are not real. They are hypothetical in the sense that while they could have earned a great return over the very long term, very few investors would have received those returns. Human behavior would have caused them to abandon the investment long before the long-term yields were achieved.

The data from a recent Vanguard study (yes, from the chief proponent of index funds) supports this conclusion. Citing Morningstar records of the behavior of investors in passive index funds, they found that most of them failed to earn as much as their passive funds returned.

60 month relative return

The reason for this abysmal experience is the behavior of investors. The actions of the market cause investors’ behavioral tendencies to take over and result in management decisions that are contrary to their best interests. For the most part, they sell low and buy high.

Now the index-fund industry has an answer for this. They spend millions each year telling advisors that it is their job to convince their clients to buy and hope—to hold on no matter what the markets do. And it’s good advice. It’s just not practical advice.

Most people have learned that if you’re standing on the railroad tracks, it’s best to get off them when a train is coming. That’s learned behavior, and it’s hard to ignore it when it comes to investing—when your starting investment of $100,000 has fallen to $45,000 in an S&P 500 Index fund or $25,000 in the NASDAQ variety.

In real life, think about how hard it is to unlearn the behavior that results in smoking or overeating. When you diet, do you unlearn the behavior? Or does your weight start to creep up on you? Some people are successful at these tasks, no doubt, but most people have great difficulty unlearning behavior.

And don’t forget, your advisor is human too. He or she has been stopping at red traffic lights his or her whole life. They don’t plow through just because someone says the road is clear.

One of the chief reasons why people say that passive investing is winning the debate is that passive funds and ETFs are growing in assets while active funds are losing them. This argument ignores the fact that passive funds are the vehicles used by active money managers. The Vanguard study supports this argument. It’s difficult to separate the active buying from a true passive investor’s buying.

The active advisor does the buying and selling of the index funds to achieve the returns that are more suitable to the risk profile of their clients. Some do this by investing in a number of passive indexes and hoping diversification and occasional tweaking will save their clients, even though this method fell short the last two times the indexes crashed 50% or more.

More and more advisors are using passive index funds to dynamically risk manage investor portfolios. They adjust the risk of investor portfolios in order to overcome human behavioral tendencies. Flexible Plan has been doing this for more than 37 years, using time-tested, computerized trading plans to eliminate the subjective while supplying the discipline to stay on a risk-management diet.

As the professor concludes, “Risk tolerance and the desire for control are not constants among the investing populace, and behavioral studies also show that they vary with age, wealth, and life circumstances, not to mention the market environment. Many investors need tailored, flexible strategies that can dial the risk level up or down according to the variables mentioned [in the article], getting more defensive or aggressive as conditions warrant. In most cases, active managers can supply these strategies better than the individuals themselves.”

For more reasons why dynamic, risk-managed investing is the way to go, check out Proactive Advisor Magazine.

Market update

Stocks delivered all of the gains last week, as bonds slumped. Stocks have rallied despite a volatile political climate. This seems due to positive economic and technical market issues. The fully invested position of our stock market strategies has proven to be on the correct side of the street.

The 2%-plus gains in the first five days of June this year are one of only 13 times this level of returns has been achieved in June since the end of WWII. On past occasions, that has led to a poor remainder of the month, with losses 10 of the 13 occasions. However, for the balance of the summer (at least through August 31) the S&P 500 has gained ground eight out of 13 times. In other words, more often than not, the softness usually experienced in the rest of the June is more than overcome in July and August.

It is also true that the stock market has reached overbought levels. We are approaching a point where we may have moved up too far too fast historically, and a pause could be in order.

This overbought reading comes from a very short-term measure (50 day), but it is being touted on Wall Street. However, when we examine the market from a broader perspective, a different picture emerges.

On the following chart, compare where we are today (the dark black line) in terms of the historical percentile range of returns over various time periods with where we were at the start of this year (the gray line). For example, at the start of the year, we were up at the 78.4 percentile mark for the one-year returns. That means that during all of the monthly one-year look-back periods since 1928, we had gone up more than 78.4% of the occurrences. Today we are at the 54 percentile level.

S&P 500 current returns percentile rank

That means we have a lot more headroom for an advance than we did in January just before the correction began. This is the case across the board. Our present level of returns has more room for growth for every time period. Furthermore, the low numbers for 10-year and 20-year returns make the stock market look positively cheap!

A number of other indicators support the continuation of the present bull market scenario, after, perhaps, a pause in the second half of June.

While we have yet to hit a new high in the S&P, my February prediction of future new highs by mid-May has finally come to pass in other indexes. Now the Russell 2000 and NASDAQ Indexes have joined the cumulative advance-decline line and surpassed their previous high-water marks. The S&P 500 has about 4% to go to make the grade. A positive conclusion to the U.S.-North Korea summit could cause such a gain to occur.

Economic reports continue to tell a very positive story about the U.S. economy. Most reports last week beat economists’ expectations. Job reports continue to top the list of positives. Jobless claims were reported at the lowest level since 1973, and for the first time in this millennium, the number of job seekers exceeded the number of jobs available, as the monthly JOLT (Job Openings and Labor Turnover) report released last week.

Unemployment vs total jobs

Of course, this is liable to stir some increased inflationary fears. We will see whether it will show up in the numbers as early as this week as we have a number of inflation reports on tap.

Of course, such a tight labor market also suggests that the Federal Reserve Board will likely feel free to increase rates yet again this Wednesday when it meets. Two more increases thereafter this year are seen as likely.

We had gotten a short reprieve from higher interest rates when the prospect of an Italian credit crunch loomed a few weeks ago. Once that fear passed, rates resumed their upward path. Rising market and Fed-induced interest rates are not usually a positive for stocks. However, as I have previously pointed out, when rates are unusually low, history tells us that they can coexist with positive stock market returns in the short term.

Much has been made this weekend of the G-7 meeting and its aftermath. The media has been mostly negative on the United States’ go-it-alone stance, with the Trump administration arguing that our trading partners either live with a world where we, like them, have tariffs or we agree on going forward with no tariffs or subsidies. Instead, they seem to like the present environment where the U.S. has relatively low tariffs or subsidies and our trading partners have much higher levels of both.

Perhaps the market is a better judge. Year to date, stock market participants are siding with the U.S., if returns are substituted for poll results. The S&P 500 has gained 4.66% while the developed non-U.S. stock index (EAFE) has gained just 0.24%, and the emerging markets index (EEM) has actually lost 1.51%.

Our intermediate-term strategies remain fully invested and leveraged where applicable. The short-term measures I monitor also remain in positive territory.

The environmental regimes are positive for stock investments. While I don’t expect our All-Terrain regime to change, there are those inflation reports this week that could reflect a change in direction. Don’t forget these regime indicators are updated daily.

Finally, in reviewing the year-to-date returns, our strategies are mostly doing nicely. Fusion continues to outpace the market and can be found near the top of the list of returns (Moderate to Aggressive), as was the case last year. Market Leaders (Growth and Aggressive) is also near the top and is available in our low-cost QFC strategies. Classic is doing best among our Tactical Domestic entries. All of these—Fusion, Market Leaders, and Classic—are easily outpacing the S&P 500 year to date after maximum fees.

If you have not diversified into Fixed Income Tactical and/or Government Income Tactical to combine with your WP Income Builder bond accounts, now would be a good time. Both strategies continue to generate better daily returns in an ever-changing bond market than both WP Income Builder and the long-term government-bond index (TLT).

All the best, and an early “Happy Father’s Day” to all of the other dads out there.

Jerry

Jerry C. Wagner is Founder and President of Flexible Plan Investments, Ltd. Formerly a tax and securities attorney, Mr. Wagner recognized early on that technology and hedge fund techniques could be applied to help individuals successfully invest, while managing their downside risk. After spending time pioneering new techniques in market analysis, designing quantitative methodologies, and managing investment portfolios, Mr. Wagner founded Flexible Plan Investments in February 1981.

PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.  Inherent in any investment is the potential for loss as well as profit.  A list of all recommendations made within the immediately preceding twelve months is available upon written request.  Please read Flexible Plan Investments’ Brochure Form ADV Part 2A carefully before investing. View full disclosures.