Active Vs Passive Investing: Which is Better?
Cats or dogs? Coke or Pepsi? Back rub vs foot rub? Debates rage on in the world and there is no clear cut answer to any of these common choices. Except that back rubs are definitely better than foot rubs (come at me, bro). But since this is an investing blog, I will center my thoughts around the exciting dichotomy of whether to trust your investments with a team of fund managers/analysts (active investing) or simply track an index (passive investing). It also bears mentioning there is no clear cut "right" way of doing things in investing. Much like cooking a steak, there are several ways to end up with a delicious steak but there are also ways to get you something that resembles charcoal.
What is Active Management Investing?
Active management investing is where a team of portfolio managers/analysts continuously monitor markets in an attempt to find opportunities for above average returns that outperform the market. We won't go into specifics but understand these professionals engage in extensive research, market analysis, and actively adjust portfolios in response to evolving market conditions on a consistent basis. Fund managers or portfolio managers may use different methods but they are all trying to do the same thing; identify mispriced securities or trends in the early stages to beat the market with above average returns. The ability to achieve above average returns in finance is often referred to as alpha. Alpha measures the ability to beat the average or what is commonly referred to as a benchmark.
Benefits of Active Investing
The obvious benefit is that when successful, active management will have higher returns than average. Isn't that the whole point of investing? Yes, but like with most difficult endeavors, if it was easy then everyone would be doing it. You are putting your trust in managers and analysts that are extremely intelligent with extensive experience but the world of investing moves quickly. With the advent of the internet it moves quicker than Tom Cruise in one of his running sequences. Even these intelligent and highly trained analysts can find it difficult to consistently pick winners. It is far from an exact science because you are basing your decisions on humans and as anyone who has ever dealt with humans can attest, they are anything but predictable.
The other advantage to active trading is the amount of flexibility and adaptability it provides. The possibilities are nearly limitless when it comes to the combination of securities and how much of each you place in a portfolio. Active funds also can buy/sell securities on a moment's notice to take advantage of brief opportunities.
Disadvantages of Active Investing
The drawbacks to active investing can mostly described into two categories: cost and risk.
On the cost side, active management usually costs more than passive investing. You are paying for a team of people to keep an eye on you investments. No different than athletes, top talent costs top money so many of the funds with a sound track record will cost more. To give you an idea of what I mean, it is not uncommon for some growth funds to charge over a 1% expense ratio on a fund.
The risk refers to the risk of underperforming the market. As I said before, beating the market is not easy. While it is not uncommon for funds to beat the market in a given year, consistently beating the market over a long period of time is quite rare. For example, this Forbes article says that "...over the course of one year, 51.08% of actively-managed mutual funds underperformed the S&P 500." It gets even worse over the long term. "Over 10 years, only 8.59% of actively-managed funds outperformed the S&P 500". This was based on data through December 2022.
So why would you ever consistently invest in active mutual funds?
First off, some funds do outperform the index. It isn't impossible.
Secondly, you are probably tired of hearing this in investing articles but historical returns do not necessarily have any baring on future returns. The fact that some funds do outperform the market says there is a method for above average performance and it is impossible to know if more funds could find the "secret ingredient" for this in the future.
What is Passive Investing?
Passive investing is the "set it and forget it" of investing. Rather than constantly manipulating your asset holdings based on trends and analysis, passive investing revolves around tracking a specific index.
Cool Joe, but what the heck is an index?
Glad you asked. An index is a way of measuring a segment of the stock market by tracking the performance of the securities that make up the index and using a weighting to track the overall performance. The easiest explanation is using an example.
One of the most common indexes is the S&P 500. It is made up of the 500 leading (not necessarily largest) companies in the U.S. If you were to buy an S&P 500 index fund, your investment would aim to replicate the performance of this index.
Here is how it works. If you were to invest $10,000 into an S&P 500 index fund, your $10,000 would essentially be split up into all 500 companies in the index. How much you invest into each company is weighted based on the market capitalization of each company, or how much the company is worth. Market capitalization is found by multiplying the price of a share of stock for the company by the total number of shares that have been issued. To find each company's weighting, you take their individual market capitalization and divide it by the total sum of all 500 companies market capitalizations. You still with me?
The largest company currently in the S&P 500 is Apple (AAPL). They have a market capitalization is $2.75 trillion which is around 7.1% of the S&P 500. Therefore, we would allocate roughly $710 of our $10,000 into Apple stock.
Next is Microsoft stock, which has a weighting of 6.51%, would get around $651 of our investment. We continue using this calculation all the way down to the smallest company.
Benefits of Passive Investing
There are not many guarantees in investing but the one thing you can guarantee is how much you will pay to invest. This is where index funds shine. They have rock bottom expense ratios that average around 0.06% annually. Compare this to some funds charging over 1% and you are roughly 1% ahead to start.
If you are investing in a taxable account, index funds are extremely tax efficient so you can avoid the higher taxes of short-term capital gains and instead pay the lower rates of long-term capital gains (as long as you hold the funds for at least a year).
Index funds are also "self cleansing." If a company shows promise and grows compared to the rest of the market, you will be investing more of your money into this company. This is because it's weighting will be higher in the index and so more of your invested money will go towards the stock. The opposite is true as well with companies who's value is dropping will command less of your investment.
Disadvantages of Passive Investing
The trade off when using index funds is that you aren't going to beat the benchmark. Your returns will never be above average because you are investing in an index which is essentially the average. Beating an index by even 1% per year can mean a huge difference in returns. If you were to invest $100,000 for 40 years, the difference between a 7% return and 8% annual return is $675,007!
Another downside to passive investing is the lack of flexibility. The index is what it is and your investment will be allocated based on the guidelines. It "stays in its lane" and doesn't allow for detours. There is little ability for the fund to take advantages of market opportunities based on undervalued securities. Active Vs Passive Investing: Which is Better?
So who is the winner?
There is no clear winner in this fight and I am not picking sides. I think active and passive investing both have their place in a sound strategy.
The decision is up to you and/or your financial advisor but be sure to keep in mind your personal feelings around aggressiveness, cost, time horizons, target returns, and taxes. Answering these questions will give you the framework to decide which assets fit into your ideal strategy. The fun part about investing is that you can always change your strategy if you find your current one doesn't work for you. Just like how you can always ask for a back rub instead of that foot rub.