Active vs. Passive Investing

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Definition of active versus passive management

The difference between active and passive management is quite simple on the surface. Active management is just what it says it is: the active management of your portfolio by choosing investments on a continual basis, including when to buy and when to sell. It may include overweighting certain stocks or sectors while underweighting or avoiding others. And while individual stock selection is considered active management, so is choosing fund managers that invest in individual securities. Throughout this article I will refer to both individual stock selection and mutual fund manager selection as active management.

Passive management is not necessarily the opposite of active management, but rather, a strategy of investing in an index or sector, through a passive exchange traded fund (ETF) that is representative of a market. While this concept has evolved due to the proliferation of ETF’s focused on narrow segments of the market, the concept remains the same. For example, the iShares S&P 500 Index ETF (SPY) invests in all of the stocks included in the S&P 500 in the same proportions that those stocks represent the index. The iShares S&P Global Technology Sector ETF is also a passive investment, but is more focused on the technology sector specifically.

Arguments for Both Strategies

Passive investing or indexing proponents argue that the best way to capture returns is by using low-cost market tracking index investments. The approach assumes that markets are efficient and that all investors have access to information about each company and its securities. Because of this, it is difficult for any one investor to gain an advantage over another investor. This line of thinking assumes that the markets are efficient.

However, proponents of active management will consider that statement to be false. They feel that while the market may be efficient in the long-term (and that may be debatable), there exist inefficiencies in the short-term that investors can take advantage of. Some investors may be employed in the profession and have access to better information or have the ability to better process that information to make investment decisions that over time can generate returns in excess of the market. The everyday investor does not have the same type of skill or access to information.

But even if all information was instantly available to all investors simultaneously, some investors may interpret the information quite differently than others. And still others will integrate that information with information about other topics, sectors, or companies, to develop a unique opinion or value of that company. While the market efficiency theory states that this information is reflected in market prices, savvy investors may be better at identifying when the price of a company’s stock has temporarily deviated from its true underlying value.

Performance of active versus passive management

It is not uncommon to hear claims about passive management outperforming active management. There are certain asset classes that are more efficient than others. In other words, passive management is difficult to beat within these asset classes, primarily because of the available information of the companies in that asset class and the depth of analyst coverage following those companies.

For example, the most followed asset class as measured by analyst coverage, media, and the public at large, are large cap US companies. One could assume that it would be difficult for an active manager to outperform the index on a regular basis and over long periods of time.

The Basic Rules

The basic rule of thumb I would propose is to find managers that have outperformed their respective benchmarks over short and long-periods of time and determine if there is a reasonable chance they will continue to perform well in the future. (Keep in mind that even great managers may underperform for short periods of time) If these managers are difficult to find, there is a good chance that the asset class you are evaluating is one of the efficient ones. If this is the case, choose passive investments to gain exposure to that asset class.

When you do invest in active managers, however, keep in mind that even the best managers go through a slump. According to a white paper by DiMeo and Schneider, 90 percent of ten-year top quartile mutual funds were unable to avoid at least one three-year period in the bottom half of its peer groups, so make sure to look at long periods of time when evaluating performance.

  • 63 percent of ten year top quartile mutual funds were unable to avoid the bottom half during a five year period.
  • Top quartile funds spent 23% of all rolling three year periods in the bottom half of their respective peer groups.

Benefits and Drawbacks of Active management

Baird Table

Source: Baird’s Advisory Services Research

Benefits

All of the benefits of active management are attributable to and dependent on your ability to outperform the market or to choose mutual fund managers that can outperform the market. If outperformance is not possible then the concept of active management fails to add any benefit to a passive investment strategy and you are better off investing in an index.

When good mutual fund managers are chosen, you create the possibility of outperforming the market through the fund managers ability to capitalize on market opportunities or the prospects of individual companies. The manager may also be able to preserve capital during a broad market decline either by choosing great stocks or staying in cash.

Drawbacks of Active Management

If you’re not a professional manager, there is a good chance that you will not be able to outperform a passive strategy over long periods of time. You may find yourself outperforming over short periods of time, like when you might have gotten on a roll in Vegas for the first few days of your vacation, only to lose it all and then some before your flight back home. Like with gambling, if you’re not a good stock picker, there is a high probability that you will underperform a passive strategy more often than not.

While choosing the right manager may still result in underperformance during some periods, over longer periods of time, good managers have the ability to outperform a passive strategy.  Unfortunately, not only are these managers hard to identify, their returns must not only beat the passive strategy, but must do so by the level of fees they charge.

Benefits and Drawbacks of Passive management

Benefits

The most often mentioned benefit of passive management is the fact that they tend to have much lower fees than the mutual funds that use active management. The argument is that, as I mentioned earlier, even if managers can outperform a passive management style, the fees charged by the manager negates this outperformance. By having very low fees, passive strategies mimic the underlying index more closely.

Secondly, if you are putting together a portfolio of asset classes and are comfortable with the inherent returns and risks of each of those asset classes, you would want your investments to mimic those asset classes. If nothing else it provides predictability of returns whether those returns are positive or negative. For example, if you were to invest in the S&P 500 through the iShares S&P 500 Index ETF, you can be sure that the returns on that ETF will be almost identical to the actual S&P 500 index. And ETF’s are much more tax efficient due to their low turnover.

Drawbacks

Unfortunately for passive management strategies, they have no chance of ever outperforming their underlying index. Ever! I hope that message is clear. A passive strategy will NEVER outperform its relevant index. Furthermore, since the passive investment mimics an underlying index and also has minimal, albeit, incremental fees, the passive strategy will always underperform its relevant index by the amount of the fees.

Applying both strategies

You don’t have to choose between an active and passive strategy for your investment portfolio. It is quite common for individual investors like us to use a combination of the two. This method can be considered another form of a core/satellite approach, which we discuss in another article.

The most common and practical way to use a combination of both passive and active management investments is to use passive strategies for those asset classes that are most efficient, and active strategies for those asset classes that are less efficient, less followed, and may require special knowledge or skills. As I mentioned earlier, large caps are a very efficient asset class because of the vast amounts of information readily available and can be considered for a passive approach.

When should you use one strategy over another? For retail investors without the time, interest, or skills to pick stocks, a passive investment strategy is probably better. A passive investment strategy is also better if you don’t have the ability to pick a good fund manager or there just doesn’t seem to be any that you are confident can outperform the market.

What type of investor are you?

The most important determination of whether to use an active or passive strategy depends on what type of investor you are. Which strategy or combination of strategies you use depends heavily on what type of investor you are. If you are passionate about investing and spend much of your time studying investment opportunities, whether professionally or not, you may prefer to have a higher proportion of your investments in active management strategies. This could be accomplished through individual stock-picking or choosing mutual fund managers with an active investment style. If you are at the other end of the spectrum, where you spend very little time following the markets and do not study investments in detail, use a passive investment strategy.

Conclusion

Active versus passive investment strategies should not be an either/or question. You should ask yourself which part of your portfolio should be invested using passive strategies and which part should be active. The right combination is unique to each person and only you could answer the question correctly. There is no magic formula and regardless of what research says, there is no definitive answer. Sometimes the best approach is to use trial and error to figure out if active management is working for each particular asset class you would like to invest in. If it does, great. If it doesn’t, then switch to passive investments and save yourself the extra fees.