The big idea and why it matters: Investors resort to passive index investing since it is cheap and easy to use, and because they don’t believe there is a better alternative. Academically backed strategies, like the Fama-French model, may lack practical utility. Higher-yielding Dividend Growth investing may solve for both of those issues.
“An investment in knowledge pays the best interest.” -Benjamin Franklin
For prospective clients who aren’t introduced to The Bahnsen Group because of Dividend Growth Investing, the question often arises as to why it’s such a vital core component of what we do for our clients. That inquiry comes in a variety of forms, but blatantly, it’s something like, “Why don’t you just use passive investing? Nothing consistently beats the market over time.”
We should ask ourselves the same question, as it’s both expensive and labor-intensive for TBG to run what we call our Core Dividend strategy of individual stocks in-house. Not that “doing less work for more pay” is the mantra of TBG (perhaps the opposite), but there’s no reason to overtly waste time and resources unnecessarily. Thus, we must firmly believe in what we’re doing – which I assure you, we do. With that in mind, today, we’ll take Ben Franklin’s advice to invest in some knowledge, eventually getting into Div Growth and why it is very possibly an Alternative Investment hiding in plain sight. Here we go!
What is meant by passive vs. active?
First, as Alt Blend appeals to (at least) 5 or 10 readers across a spectrum of investment experience, let’s ensure we’re on the same page regarding passive investing. You can click here for the extended Investopedia definition, but concisely, it involves buying an investment that effectively replicates the returns of an index. For example, investors can purchase an S&P 500 ETF that provides the same return as the S&P 500 (often referred to as “the market” in the US) generates, minus some small fees. These types of investments are cheap and easy to run.
With passive strategies, there isn’t any potential to outperform the indexes they replicate, but they are dependable – especially the ones that are well-constructed, large, and frequently traded. The appeal of active investing – where the underlying holdings are selected based on a methodology that differs from that of a given index – is the opportunity to generate better returns than the market. The downside? You can also do worse (much worse) than the market. Passive evangelists put the odds of consistently beating the market at basically zero, so it’s not worth taking the risk or bearing the additional costs of using an active strategy.
It depends on what your definition of “consistently” is
A strategy that beats the market over time doesn’t need to outperform every day, month, or even every year. A helpful way to put this into perspective is to consider how often the market underperforms other strategies. In any given year, many investment strategies (there are thousands) will beat the market, but I’ve never heard a Passive advocate tell me about how often the index strategy loses. However, to be fair to the Passive crowd, a) a strategy beating the market for a year doesn’t mean it will continue to do so (probably just the opposite), and b) many strategies don’t beat the market. And there is a consistent media drumbeat touting the perils of active investing and Why it’s so tough to beat the market. So, why even try?
Problem Du Jour?
If you’ve heard of the Fama-French model, then you likely work in finance or are otherwise at least a financial wonk. Professors Eugene Fama and Kenneth French won a Nobel Prize for their work that (in very general terms) helped to conclude that small-cap value stocks tend to outperform their peers (and the market) over time. In other words, buying smaller companies (“small cap”) at more reasonable prices (“value”) should yield better returns over the long term. It sounds pretty easy and almost intuitive, right?
Fama-French and the related small-cap value (SCV) bias were a topic of discussion for a while, and I anecdotally recall a lot of discussion about it 10-15 years ago. But I haven’t heard much about them for some time, and it’s likely due to performance. Comparing a standard small-cap value ETF to a commonly used S&P 500 ETF, my FactSet screen indicates that SCV has underperformed the S&P 500 by nearly half over the past decade. That’s tolerable if it’s a few percent, but we’re talking more than a 100% gap between the two (feel free to reach out to me for the data).
What’s worse? When I shrink the timeframe of about 4 years, the SCV return is basically flat. And what’s even worse than that? SCV isn’t a market segment known for providing a lot of income. In fact, the ETF in question pays zero dividends. So, now imagine I’m a retiree watching my SCV portfolio grind sideways while needing to generate income to fund my lifestyle. Hopefully, this hypothetical small-cap value devotee has a diversified portfolio and adequate cash reserves to plan for these times. However, pouring salt in the SCV wound is that their bonds (using a Bloomberg Barclays Aggregate ETF) are negative over the same timeframe. At least they kick off some income along the way.
Might small-cap value still outperform over the “long run?” Yes, but a retiree’s portfolio may not survive to benefit from that (hypothetical) recovery.
Risk management
Four years is surely not “long term,” but I’d argue that 10 years is starting to get in the ballpark of what most humans deem to be a reasonably long time. Even if we define a “long time” as 20 years, then SCV needs a massive amount of recovery to catch back up to the market over the next 10 years, let alone outperform. This situation could shape up to be one of the most painful trades in history or one of the greatest opportunities of all time. Fortunately, I don’t think we have to bet on either of those outcomes.
Hope isn’t a strategy
Yes, we want to put the odds in our favor of outperforming the market over time. We also cannot sit around and hope that the market rises to help replenish our cash reserves over time. Markets can go sideways for quite some time, which has led to the notion of “lost decades.” Therefore, it would be great to have a mechanism that a) helps savers benefit from price volatility and b) provides spenders (aka retirees) a consistently growing livable wage that is detached from current market conditions. Higher-yielding dividend growth (HYDG) stocks are the right candidate for the job. But don’t take my word for it: this article from Greenrock Research (h/t to our friend Mitch for the link) sets the stage for HYDG being a valuable alternative to passive investing and for us to do a deeper dive on this topic in the next edition.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
