Art by Gérard DuBois

Nearly a decade ago, Warren Buffett made a bet: Over a ten-year period, and judged net-of-fees, the S&P 500 would beat a portfolio of actively managed hedge funds. Active investors, he argued, would, in aggregate, do just about average—so why not skip the fees and get those same average returns in the form of an index?

Almost ten years later, Buffett’s logic holds sound. With a little less than a year to go, the Oracle of Omaha is easily winning the million-dollar bet, thanks in part to an eight-year bull run in US equities. (Challenger Protégé Partners’ decision to go with funds-of-funds—layering additional fees on top of the existing hedge fund fees—did not help its cause.) Buffett is not the only investor to embrace average in recent years. Assets have flooded into passive strategies as investors—retail and institutional alike—have opted out of active management and into low-cost indexes. In 2016 alone, Morningstar reported a record $504.8 billion in asset flows to passive funds. Meanwhile, actively managed mutual funds suffered outflows of $340.1 billion as investors grew increasingly dissatisfied with paying high fees for low performance.

But even as allocations to indexes grow higher than ever, pure beta portfolios aren’t looking as good as they once did. In the early years of Buffett’s bet, the S&P 500 delivered double-digit returns as markets bounced back from the recession. But today, with allocators, managers, and consultants all predicting diminished gains in the years ahead, consensus estimates place future expected returns for a classic 60/40 portfolio at no better than 5%—well below the performance levels necessary to fund pensions and keep endowments around in perpetuity. Moreover, an aging bull run means heightened probability of volatility—putting index investors at risk of absorbing the full brunt of a significant drawdown.

Manager’s Performance in Bond Market (5-Year Returns)

Passive funds may, as Buffett argued, guarantee average results at minimum fees—but management fees aren’t the only premium associated with investing. What, then, is the true cost of being average?

Let’s just get this out of the way: In pure expense ratio terms, indexes are a bargain. An index tracking the S&P 500—such as Buffett’s pick, the Vanguard 500—can be had for under 20 basis points, and other passive funds are similarly inexpensive compared to their actively managed counterparts. If you want broad exposure to a market segment, indexing is the cheapest way to go.

“The only sure thing in investing is fees,” says Jay Love, an Atlanta-based partner at Mercer Investment Consulting. “Excess returns are a maybe. Fees are definite. Trying to minimize fees is a good first step.”

Take into account the fact that the majority of active managers have underperformed the index in most markets over the past five years, according to S&P Dow Jones’ SPIVA database, and it makes sense that investors would turn to the cheaper alternative.

“If a cheap index is beating managers, why not just buy the index?” asks Tim Bruce, director of traditional research at NEPC. Index investors, he explains, got serious bang for their buck in the years immediately following the recession, when the S&P 500 grew rapidly as markets recovered.

“Starting in March of 2009, all you wanted to do was own the S&P 500,” he says. “It didn’t matter how cute you were with your managers and asset allocation—you would’ve done really well just by owning the S&P 500 and core bonds. Investors don’t have an unlimited tolerance for underperformance, so they gave it about three years before they said, ‘Okay, I’m done,’ and started taking money out of their active managers and just buying indexes.”

The result? Passive flows spiked in 2012—and have only continued to grow.

“There’s definitely been a continued flow of assets into passive strategies out of active strategies,” says Lori Heinel, chief portfolio strategist at State Street Global Investment Advisors (SSGA). “With fixed income in particular, we’ve seen more of an appetite and interest in passive approaches than there had been historically.”

Although the majority of asset owners still retain at least some active managers, there are those who have fully embraced passive. Take the Nevada Public Employees’ Retirement System (PERS), for example.

Since he was named CIO in 2012, pension chief Steve Edmundson has brought the $35 billion fund to 100% passive positions in its public markets allocations, which account for roughly 90% of the total portfolio. (A 10% private markets commitment, invested with private equity and private real estate managers, rounds out the fund.)

“We see indexing as the most efficient, cost-effective tool to get the market exposures that we’re looking for,” Edmundson says. The CIO is quick to point out he has nothing against active management per se—”We’re not making a statement that active management can’t beat indexing,” he says—it’s just that he believes the time and energy necessary for manager selection could be better spent elsewhere.

“Asset allocation is what drives—depending on what study you look at—in excess of 90% of investor returns,” Edmundson says. “We made an overt decision to focus on what’s going to drive our total fund returns.” With active managers, he adds, allocators often end up “handing over the keys” to asset allocation to some extent. Indexing provides the exact exposures Nevada PERS wants—and it’s inexpensive.

“We keep our fees among the lowest in the industry,” he says. So far, the strategy has proven successful. The fund returned 9.8% in the year ending in September 2016, with three- and five-year returns of 7.1% and 10.1%, respectively. Performance has been driven largely by the portfolio’s sizeable allocation to the S&P 500, which has continued to rise eight years into the current bull run. But while investing in the index has cost the pension very little in terms of fees, an un-hedged exposure to risky assets comes with a price. 

Manager’s Performance in Equity Market (5-Year Returns)

“We’re all always focused on returns, but we can’t forget to think about the risk side,” says Mark Baumgartner, CIO at the Institute for Advanced Study. “If we were just concerned about returns, we would have no trouble—we could just lever up a passive investment in equities and get whatever return number we want. The issue is that we’d be required to take unacceptable levels of risk to get those returns.”

For Baumgartner, as CIO of a sub-billion dollar endowment responsible for roughly two-thirds of his organization’s budget, “unacceptable” means risking a loss of more than 15% at any given time. With such a strict risk budget, he can’t afford to invest in indexes—regardless of how cheap the fees are. “By investing passively, you’re achieving your fee objective— you’re paying almost no fees,” he says. “But you may fail on your main objective, which is to deliver your return target at an appropriate level of risk.”

Being average might mean you never underperform the market—but it also means that when the market crashes, so does your portfolio. And today, with the market cycle growing older by the minute, and with volatility predictors like the Chicago Board Options Exchange’s SKEW Index reflecting heightened fears among investors, the risks inherent in passive investing are worth reexamining.

“There are a number of unknowns in the world,” SSGA’s Heinel says. “The policies of the new administration could certainly lead to some skittishness in the market; there’s a number of upcoming elections in the Eurozone; Brexit is still being sorted; there are concerns about a China slowdown. So there are clearly a number of risks out there that could lead to another drawdown, and it’s wise for investors to think about volatility and how that might impact them.” For example, passive investing may not always be in the best interests of a fully funded pension plan.

“Their primary worry isn’t returns; it’s losses,” says Bruce at NEPC. “Indexes are volatile, so if you’re trying make sure you don’t lose money, you’re tilting the lever closer toward active and you’re focusing on protecting against volatility.” On the other hand, the consultant adds, an underfunded pension has to be discerning about where it can splurge on active management.

“If you’re at the other end of the spectrum and you’re saying, ‘Listen, we’ve got to make some serious return here,’ then you’re definitely going to be more passive because you don’t want to pay the fees,” he says. “And where you are active, you have to focus on the highest return-seeking areas like private equity and emerging markets.” A passive portfolio like Nevada PERS might be more risky—but as Edmundson puts it, volatility is a price return-seeking investors have to pay.

“I don’t think anybody’s going to escape market volatility, whether they’re actively managed or indexed,” the CIO argues. “What’s going to be the deciding factor is how much of your fund is allocated to risk assets—and anyone with a total fund return objective north of 7% is going to have to embrace investing in volatile assets.”

What happens when return objectives become harder to achieve? Average is great in years like the period between 2009 and 2012, when returns were abundant. But what about in low-return environments? With just about everyone predicting diminished beta in the years ahead, the true cost of indexing may not be low fees or volatility, but a much higher price: insufficient outcomes.

“The expectation that I have, and that many have, for passive investments going forward is not strong,” Baumgartner says. “It’s a lower-than-typical return at higher-than-typical risk. You’re just going to have to look elsewhere for returns.”

Rob Manilla, CIO at the Kresge Foundation, agrees. “The reality is no matter whose forecast you use, no one has asset allocations that tend to earn 7.5% going forward,” he says. “So what are my choices? My choices are to take more risk, lever my portfolio, and find active management to make up that difference through alpha. Being average isn’t an option.”

“We’re not going to spend any time looking for active managers in efficient markets—but in markets that are less efficient, we spend a lot of time, energy and effort trying to find managers we think can generate alpha.”

Over the past decade, Manilla has succeeded in generating significant alpha in his equity portfolios by taking active bets in inefficient markets. Two-thirds of the Kresge Foundation’s domestic equity investments are in actively managed small-cap funds, while the foundation’s hefty emerging markets allocation is 100% actively managed through individual country mandates. The result? Annualized excess returns of 2% in US equities and 9% in emerging markets over the last ten years.

“We are big believers that active management can work in less-efficient markets, and it’s been proven out in our history,” Manilla says. “We’re not going to spend any time looking for active managers in efficient markets—but in markets that are less efficient, we spend a lot of time, energy and effort trying to find managers we think can generate alpha.”

The approach is in line with what consultants like NEPC and Mercer recommend as the best practices for active management: Stick to inefficient markets, find managers worth their fees, and make sure you know exactly why a strategy is going to work—because if you don’t know, it probably doesn’t work.

“Active management is difficult,” says Mercer’s Love. “It’s a zero-sum game. For everybody who outperforms, somebody underperforms, and just because you need higher returns doesn’t mean active management is going to give them to you. If you can’t identify why you’re going to win, you’re probably the loser.”

Even following all the rules doesn’t guarantee you’ll hit your return target. As Baumgartner points out, “true alpha” is difficult to find, and many funds face constraints that make excess returns hard to come by.

“We’re all challenged to meet our objectives, and when you add in investment constraints—if you’re geographically constrained or you can’t invest in certain stocks or your portfolio is of a size that a meaningful investment is too small to move the needle for you—all of those things make it even harder,” he says. “The likelihood of success for various organizations in the next five or ten years is very low in my mind, and it gets lower the bigger you get. The less alpha you can bring into the portfolio and the less diversification you have, the worse your outcome is potentially going to be.”

Size, it turns out, does matter—at least when it comes to active management. A small endowment like the Institute for Advanced Study or $3.5 billion fund like the Kresge Foundation can succeed in finding alpha because they are small enough to access it. But a mid-size pension plan like Nevada PERS isn’t so well-positioned.

“The larger your portfolio gets, the tougher it is to generate abovemarket returns,” Love says. “Somewhere after $10- or $15 billion there’s just not enough capacity in a lot of the more attractive areas or niche asset classes to put money to work in a meaningful way.” Buffett’s bet, after all, hinged on the idea that active investors are no better than average when taken in aggregate. The larger a fund, and the more managers necessary to fill an active mandate, the more the portfolio will resemble the aggregate—and the aggregate isn’t looking so great. As NEPC’s Bruce points out, the same 1% management fee on an active investment eats up a larger portion of the total return when the returns are under 5% then when they’re over 10%. At that point, why not just take the low-fee option? Indexing may not be enough to get returns to 7.5% in the coming years—but at least for some investors, it may still be their best bet.

In investing, as with everything, there are prices that must be paid. Sometimes it’s management fees. Sometimes it’s taking risk. And sometimes it’s recognizing that return expectations might not be realistic.

“We did a study a year ago that was kind of alarming,” Heinel says. “We asked 400 institutional investors globally what their expected portfolio returns were on a prospective basis, and the average was over 10%. By our own estimation, we think a balanced beta portfolio is likely to deliver something south of 5%. That’s a pretty big gap.”

The truth is the cost of meeting objectives is high, and getting higher. Passive investing or active management—neither method guarantees that pensions will be paid or endowments won’t shrink. But CIOs like Manilla and Edmundson aren’t giving up: They have something worth betting on.