Legendary value investor Warren Buffett has always been an active manager – buying stocks of individual companies. However, during Berkshire Hathaway’s 2020 annual meeting, he reiterated advice he has offered in prior years: “For most people, the best thing to do is owning [sic] the S&P 500 index fund.” That’s been sound advice recently: the S&P 500 has outperformed many active managers in the last few years. (See Peloton’s blog “The Narrowest of Markets” for insight into recent index outperformance.) Fees for S&P 500 index funds and ETFs are also very low. Is the “Oracle of Omaha” right? Should we ALL just passively own the S&P 500 and forget about active strategies?

Peloton’s answer to that question is a confident “no.” However, we approach Buffett’s advice with respect, acknowledging his wisdom, and with the awareness that passive investing is right for investors in certain circumstances. But it is not right for every investor, or even most in our opinion. In this blog we explain how we think about the tangible benefits of different investment strategies, including both active and passive options.

Fees

In a recent conversation with a financial planner, we learned he recommends that his clients invest only in an S&P 500 fund until they accumulate $500,000. However, that advisor still charges an asset-based fee for his financial advice. If fund managers like Fidelity Investments now charge a 0% management fee for certain index funds and planning is your value proposition, charging an asset-based fee might not jive. If having your clients merely invest in the S&P 500 is most suitable, wouldn’t a flat or an hourly fee for planning services make more sense?

In our view, we owe it to our clients to offer investment management strategies that meet tangible needs – ones which cannot be satisfied by investing in index funds. We also offer financial planning services through our Private Client Group, but if we are not also managing their investments, we charge clients a flat fee for the planning work. Frankly, if all you want is a passive investment in index funds, you need not pay anyone to do that for you.

Indexing Doesn’t Always Work

As we wrote in “The Narrowest of Markets,” the S&P 500’s YTD 2020 performance has been generated by only a few large technology stocks. Over longer periods, we see that sometimes indexing performs well, and sometimes it does not. The graphs below show the annualized returns for S&P 500 sectors for the two most recent decades. Here’s a key observation: outperforming the S&P 500 Index during 1999-2009 required only that investors underweight positions in Financial Services and Information Technology:

However, in the decade ending December 31, 2019, outperforming the broad index was much harder. In fact, unless you held an overweight position in Health Care, Information Technology, or Consumer Discretionary Stocks, you very likely underperformed:

Sector weighting relative to an index is an important means of attributing active performance. Thus, using sector performance as a proxy for active management, the lesson we take away is this: sometimes indexing pays off, other times it does not. Unfortunately, you cannot know which will happen ahead of time.

Meeting Tangible Needs

Peloton offers two broad services: Investment Management and Private Client Group. Our Private Client Group offers planning services, but also custom portfolio design and management. Custom portfolio structuring means that we manage portfolios geared to meet specific capital appreciation and cash flow needs for each unique client. Often we begin managing custom portfolios for clients as they approach retirement. Managing portfolios to grow and provide income in a sustainable way is a service that adds value, and it meets very tangible needs. However, balanced custom portfolios will likely never match the return of the S&P 500 over long periods of time because they include fixed income (bonds) to reduce risk and to provide consistent, reliable cash flow for distributions.

In our Investment Management service offering, our Fundamental Growth and Tactical Income strategies are geared to perform well compared to the benchmarks, over time. The minimum suitable length of time to judge the relative performance of an active strategy is a market cycle: from one business cycle peak to the next, which is roughly five to seven years. But our Durable Growth and Equity Income strategies satisfy needs other than basic relative performance. Durable Growth offers investors exposure to a thoughtfully managed portfolio of stalwart companies: firms with dominant market positions and “fortress balance sheets.” These companies’ stocks do fluctuate, but the underlying businesses are very sound. Our Equity Income strategy invests in companies with above average and growing dividends – very important features given the historically low yields currently available from bonds.

Tax and Gift Strategies

Taxable investors and investors with charitable gifting plans enjoy significant benefits from owning individual stocks. To illustrate, let’s suppose the S&P 500 appreciates by 10% in a given year. The only strategic tax-planning decision involves whether to sell some and pay the capital gain (the answer is usually no!). But a managed portfolio of stocks that also returns 10% could be comprised of some stock positions that return -20% and others that finish the year up 30%. A taxable investor can realize the loss in those stocks which have declined and use the loss to either off-set other capital gains, or to reduce taxable ordinary income, by up to $3,000 per year.

Imagine a second scenario involving another investor who gives generously to charities. If they were to gift shares of an S&P 500 Index fund up 20% or 30%, it might not be worth the effort to enjoy the modest long-term capital gain tax saving. But consider the investor who holds a stock which has doubled or more. Gifting those shares helps the investor avoid significant capital gains taxes.

Matching gains and losses and using individual stocks to satisfy gifting plans are integral parts of portfolio management at Peloton, ones that cannot be replicated as easily with an index fund.

Conclusion

For certain investors, we agree with Mr. Buffett: the S&P 500 Index is a very suitable alternative. For example, we see many 401(k) and 529 college saving plans with substandard and expensive actively-managed mutual fund choices. In these cases, we often recommend that our clients selectively use index funds in those accounts – and we don’t charge them for that recommendation. But for many other investors – like the ones illustrated in this blog – actively managed investment strategies offer significant tangible benefits.

Disclosures

Past performance is no guarantee of future results.  Peloton does not own shares of Fidelity Investments mutual funds for its clients. For a complete list of our holdings, please refer to our most recent 13-F filing.

Investing involves risk, including possible loss of principal.  Diversification may not protect against market risk or loss of principal.  The opinions expressed above should be construed as neither investment advice nor a solicitation to buy or sell securities.  Actual investor results may vary.

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