Is Active Investing Better Than Passive?
Philosophically most investors fall into one of two camps when it comes to selecting mutual funds. Some prefer actively managed funds while others have a preference for those that are passively managed. What’s the difference? According to Investopedia, active managers rely on analytical research, forecasts, and their own judgment and experience in making investment decisions on what securities to buy, hold and sell. They believe it is possible to outperform the market (and market indices) through strategies that aim to identify mispriced securities. Followers of passive management believe in the efficient market hypothesis, making it impossible to beat the market consistently. As a result passively managed funds mirror a market index, and are generally less expensive to own.
There has been plenty of research over the years touting the benefits of one side vs. the other. Not surprisingly, you can find justification for either approach. Most recently, Tom Roseen of Financial Planning Magazine took a look at the performance of active vs. passive mutual funds since 2009 to see how each type fared. After removing the outsized returns of bear-oriented or leverage-focused short-bias funds, leveraged equity funds and leveraged fixed income funds, he found that through October 31, 2014 actively managed funds outperformed their passively managed counterparts not just in 2014 but for the one-, three- and five-year prior periods. This was true for equity funds as well as bond funds, with the biggest spreads (0.59%, 1.27%, and 0.36% respectively) applying to equity funds.
However, before you run out and replace all your index funds and ETFs with actively-managed funds, consider the following:
- According to Lipper’s 2014 Quick Guide to Open-End Fund Expenses, the average actively managed fund has an annual expense ratio of 1.10% (as compared to 0.83% for passively-managed funds). Active funds must beat their benchmarks (on average) by that much just to break even.
- Investors during this period (2009 – 2014) have pumped more than $1 trillion into passively-managed equity funds vs. just $363 billion into actively managed equity funds, reducing the latter’s proportion of total net assets from 76% to only 68%. Clearly there’s been a huge preference for passive over active during this period at least for stock funds. (By contrast, actively-managed fixed income funds took in $914 billion as compared to only $371 billion for their passive alternatives).
- One of the arguments favoring actively managed equity funds is their operational flexibility. Not only do they have the ability to vary their cash positions depending on market conditions, they can buy more when prices are low and sell more when prices are high (as compared to passive funds). Theoretically this should result in lower volatility as well as higher returns. But Roseen found that when actively managed funds beat or underperformed their stated benchmarks, they did so with much more magnitude than did their passive counterparts. In other words, there is greater volatility/risk in the actively managed group.
- The period of this study is quite short in investment horizon terms. It does not even represent a full business cycle. In a 2009 report, Thomson Reuters chief index strategist Andrew Clark showed there were times when risk-adjusted returns of passively managed funds clearly outperformed active funds (most significantly between 1994 and 1999), but also times when the reverse occurred (e.g. during the last five years).
I am on record as stating unequivocally that no one can predict the future, and predicting the future is what active management is really all about. With bond funds I believe that you can and should benefit from active management, because there are many ways to squeeze out costs and improve returns when selecting and purchasing bonds regardless of interest rate movements. But the same is not true for stocks. Even if you can find a fund manager who has done well for a number of years, inevitably he or she underperforms at some point. Since the goal of all investors is (or should be) to minimize the risk associated with the return needed to support your future goals, perhaps the best approach over the long run is to utilize both active and passive funds. Portfolio diversification does work, and active vs. passive represents an additional dimension that investors can utilize.