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The great debate between active and passive investing

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The great debate between active and passive investing
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“Any philosophy that can fit in a nutshell belongs there.”

That bit of wisdom goes double for investment philosophy.

For several decades the financial industry has been promoting passive investing to many investors, especially those who are just getting into the market. The intention here is good. It’s based on the notion that many people are hesitant to start investing because they feel they lack the knowledge and/or time to actively manage their money, and thus would benefit from a largely hands-off approach. While passive investing is certainly a legitimate strategy, I believe this simple set-it-and-forget approach is, well, too nutshell.

Defining active investing vs. passive investing

Passive investing involves owning the market or a broad market index fund and never trading it. As a reminder, you can’t own an index, only a fund that attempts to track an index.

Active investing is by nature anything besides a pure “buy and hold” strategy of a particular index fund. In fact, there really is no such thing as pure passive investing, just various degrees of active investing.

Here’s what I mean. If an investor chooses to hold the S&P 500 index fund — widely regarded as a passive strategy — that person is actively choosing to invest only in U.S. stocks. That’s an active decision to exclude about 90% of the world’s more than $240 trillion investable marketplace, including U.S. small- and mid-cap stocks, the U.S. bond market, international markets, etc.

So, let’s talk performance. Is it true that the vast majority of active funds are actually outperformed by their index fund counterparts, as recently media reports seem to indicate? Some do and some don’t. But it’s not nearly as one-sided as most headlines would have you believe.

True, a Standard & Poor’s study recently highlighted in The Wall Street Journal claims that more than 90 percent of actively managed large-cap equity funds underperformed their index over the past 15 years. But a recent PIMCO/Morningstar study shows that the majority of active bond funds and bond ETFs do in fact beat their index fund counterparts.

The data confirms that in most bond categories (short term, high yield, intermediate, etc.), index funds trailed their active fund counterparts over the past one, three, five, seven and 10 years. Interestingly, 63% of these funds beat their passive index peers over the past five years. The study goes on to show that stock (or equity) mutual funds don’t fare quite as well against their passive competition; but about one-third of active stock funds do best their passive competition on a one-, three-, five-, seven- and 10-year basis.

So, in reality, both active and passive investment vehicles have significant merit. Notice I said vehicles. Both active and passive vehicles can shine. But there’s a distinction to be made between investment vehicles and an overall investment strategy or approach as defined. This brings me back to my earlier point: There really is no such thing as pure passive investing, just various shades of active investing.

(Be careful when buying allegedly “active” funds. Up to 70% of such vehicles intentionally follow the market index very closely, usually as a way to protect the fund manager’s job, according to veteran market watcher Bill Miller. This passive-type approach doesn’t stop these funds from charging significant fees.)

And, in reality, passive investing doesn’t provide that much comfort. On one hand, employing a fully passive investment approach can leave investors feeling that they are missing out on the potential for bigger gains, especially when the market is flat.

On the other hand, the majority of individual investors have little tolerance for dramatic market moves, which too lead them to engage in ill-timed buying and selling. Rarely have I met an investor who has owned one index fund through an entire market cycle; the emotional reality of this approach is almost always too much to bear.

One way to counter the impact of emotion is to work with a financial advisor.

Investment professionals can bring balance to a portfolio by tamping down emotions and talking clients though those palpable moments of fear and greed. The result is more rational investment decisions.

Based on extensive research, Vanguard, one of the world’s largest investment companies, has found a quantifiable increase in return when investors work with a financial advisor. Vanguard calls this advantage the Advisor’s Alpha. When certain best practices are followed, the result can be an Alpha in the 3% per year range. That’s not small change.

Whether or not you work with an advisor, the questions to answer here are what approach to investing and what vehicles for investing will work best for you considering the extreme emotions that come with watching your hard-earned money rise and fall with the irrationality of world markets.

After meticulously reviewing the most recent data on active vs. passive investing, I have come to the following conclusion: Most investors will benefit from a combination of low-cost active and passive vehicles. Such a strategy requires more engagement and effort from the investor – and it won’t fit in a nutshell. But it’s the best way to make sure you don’t retire on peanuts.

Disclosure: This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.

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Wes Moss About the author:
Wes Moss is the host of Money Matters – the country’s longest running live call-in, investment and personal finance radio show – on WSB radio. He is the Chief Investment Strategist at Capital Investment Advisors (CIA), and a partner at Wela, a digital financial advisory service. In 2014 and 2015, Barron’s ...Read more
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