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The Great Debate: Active vs. Passive Investing

Aug 16, 2017 | 3 min read | Ilana Polyak

Key Takeaways

  • Average is good. Don’t expect to outperform the market when index investing.
  • Average performance may come with lower fees.
  • Active investing can come in handy, since managers seek to find holes in the market.

 

The debate around active vs. passive management has been raging for the better part of four decades, ever since indexing became widely available to individual investors. Lately, it seems investors have tended to favor passive management, if their fund-buying behavior is any indication. 

 

 

In 2016 alone, investors allocated a record-breaking $504.8 billion in new money for passively managed funds. At the same time, they yanked $340.1 billion from active funds, according to researcher Morningstar Inc

What do investors find so appealing about passive investing? And can there be upsides to taking a more active approach?

 

The argument for indexing

Passive investing is built on a simple premise: Rather than try to guess which stocks or bonds will do well, investors should simply be in the market by identifying which index they want to follow. 

For instance, the Standard & Poor’s 500 index is composed of 500 large-company stocks, ranked by market capitalization (the value of a company based on share price and total shares outstanding). Funds that follow the index buy shares in all 500 companies in the exact proportions as they appear in the index. Index managers aren’t hoping to outperform the benchmark; they measure success in how closely their returns match the index.

Active managers, on the other hand, try to identify those securities that have the potential for outperformance. It can take tremendous skill and effort to routinely select securities that outperform year in and year out, something that few investors  are able to accomplish.

According to the S&P Indices Versus Active (SPIVA) 2016 Scorecard a semi-annual report comparing actively managed funds to their benchmarks, fewer than 8% of large-cap managers outperformed over a 15-year period, and only 4.6% of mid-cap (stocks of midsized companies) and 6.8% of small-cap (stocks of small companies) managers beat their benchmarks. 

What’s more, because indexing doesn’t rely on human managers to pick investments—only computer algorithms—it usually costs less, which may help further improve performance. According to 2016 Morningstar research, fees are the single most important determinant of a fund’s success.

Index funds keep their fees down in other ways, too. Because they only trade stocks when there’s a change to the index—which usually happens only a few times a year—they are able to keep trading commissions down, a savings they pass on to shareholders. Furthermore, the funds tend to be more tax efficient because, with less frequent trading, there are fewer capital gains to pass on to investors.

 

Active investing can play a role

Even though passive investing has many advantages, active funds can also play an important role in a portfolio. There are periods when active investing has the advantage, particularly during down markets. 

Because of their flexible mandates, active managers are able to sidestep falling securities and focus on defensive plays. For example, when the subprime mortgage bubble burst in 2007 and stocks swooned in 2008 in the midst of the financial crisis, managers who avoided financial-services stocks performed better than the market. In a Bloomberg analysis of 10-year sector returns, the S&P 500 was down 37% in 2008, while financials fell by 55%. 

A core-satellite strategy is a method that combines the best of both passive and active investing. Investors can utilize index funds to build a low-cost and diversified core portfolio, while also investing in active funds in specialized areas, as a complement. The satellite positions have the potential for outperformance and downside protection.   

 

What you can do next

Investing involves risk and losing money is a possibility. Whether you prefer to cast your lot with the market or you’re holding out hope for outperformance with actively managed funds, do your research. You may want to consider funds from established firms and managers with long track records (note that past performance is no guarantee of future results). And pay careful attention to fees. Even seemingly modest fees can add up to big bucks when you’re investing over decades.  

Please consult with your financial professional regarding your personal circumstances when selecting an investment strategy.

 

Ilana Polyak is a freelance writer who specializes in personal finance and the financial advisory industry. Her work has appeared in The New York Times, Barron's, Kiplinger's Personal Finance, Bloomberg BusinessWeek and CNBC.com, where she is a frequent contributor.

 

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