Active vs Passive Investing

Active vs Passive Investing: The Debate Continues

Active vs passive investing.  The debate over which is strategy is superior has raged on for what seems like an eternity.  And even though passive investing, or indexing, has become so popular of late, millions of investors still prefer a skillful active manager over a robotic index fund.

Whichever side of the argument you fall on, you have a decision to make when it comes to managing your portfolio.  Here’s some background on both strategies, and a summary of some mainstream research on the topic.  If you can put this research to use, you’ll be far better off than most investors.

 

Active vs Passive Investing

 

Indexing

When you think of the term “stock market,” what comes to mind?  Most people visualize walls of computer monitors, people yelling into phones and running around frantically, and papers being thrown in the air.   But as you know, the actual market is just the place where securities are traded every day.  And today it’s largely run by computers across several semi-quiet trading floors in New York.

But what does it mean when we say the market is up or down 50 points?  Rather than track the trades of every single stock trade (there are millions, by the way), it’s far easier to create a proxy, or index.  Simply put, an index is a group of securities used to represent a specific portion of the market.

The most prolific index is the S&P 500, which represents large cap stocks in the United States.  As you know, there are a ton of large publicly traded companies in the U.S. – far more than 500.  To represent the performance of the entire group, the S&P 500 takes the largest 500 of them based on market capitalization (number of shares in existence times the market price of each share).

There are thousands of different indexes out there beyond the S&P 500.  Some are built to track specific asset classes, while some are used to track sectors or investment styles.  For example, in addition to the S&P 500, Standard and Poor’s has an index that tracks just the technology sector in the U.S., and another that tracks large cap value stocks in the U.S.

 

Passive Management

As you probably know, indexing is an investment strategy.  The objective is to invest in an entire asset class by purchasing every single security in the index.  If you wanted to invest in large cap U.S. stocks, you could select an index like the S&P 500 or the Dow Jones Industrial Average and buy an equal number of shares of each stock in the index.

Logistically, it’s far more cost effective to buy index funds than it is to buy every security.  But the strategy is the same.  In both formats, your portfolio is invested without preference to individual securities.  This broad based, diversified investment strategy is known as passive management.

 

Active Management

As you also know, many MANY investors prefer to pick individual securities.  Rather than invest in every security in an index, active managers make investment decisions on individual securities within the same universe.  Their objective is to invest in the stocks that will outperform the index, and avoid the stocks that won’t.

In other words, active managers have an opinion about the future performance of every single security in a given universe.  Passive managers don’t.  Instead, they buy one of each.

Hiring an active manager can be expensive.  In order to develop these opinions, active managers must “grade” each security effectively.  This takes a significant amount of time, resources, expertise, and skill.  Far more than what’s necessary in an indexing strategy – which is why actively managed funds are more expensive than index funds.

The Debate

The argument over active vs passive investing mainly comes down the value that active management provides.  Logically, the additional return an active manager produces by picking individual stocks must be consistently greater than the additional fee for their services.  If it’s not it would make no sense to invest with them; investors would be better off investing in an entire index.

Here’s an Example:

Let’s say we have two mutual funds to choose from:

  • Mutual Fund A.  An actively managed, large cap U.S. stock fund.  It has an annual expense of 1% and uses the S&P 500 as a benchmark.
  • Mutual Fund B, which is an S&P 500 index fund.  Since no individual security analysis is required, it’s annual expense ratio is only 0.10%.

Now let’s assume that over the last 12 months the S&P 500 saw returns of 7.5%.  The funds have the following returns before fees:

  • Fund A: 8%
  • Fund B: 7.5%

Here are their returns after fees:

  • Fund A: 7%
  • Fund B: 7.4%

Even though the investments in Fund A had the best returns, the cost of Fund B were high enough to leave it with lower net returns.  In other words, the return produced by active management in Fund A did not justify it’s additional costs.  If instead Fund A returned 20% every single year, I’d be more than happy to invest with them for 1% per year….I’d even be willing to pay more than 1%!

Technically speaking, sometimes you’ll hear financial professionals talk about alpha and beta.  Beta is the return of the market.  Alpha is any additional return produced by active management.  This might come from individual security selection, market timing, or other strategies.  And more often than not, alpha is inconsistent enough that it doesn’t justify the additional cost.

 

Active vs Passive Research

The above example is purely hypothetical – but it does resemble most contemporary research.  Here is a summary of three papers mostly accepted throughout the financial planning community:

Eugene Fama and Ken French, 2010

In the investing world, Warren Buffett is one of the few people more famous than Eugene Fama and Ken French.  Fama and French are on the academic side of the investing world, and are known for their efficient markets hypothesis and the capital asset pricing model.  Their paper in 2010 examined the performance of active investment managers and compared them to index investing.

Their paper found that active investment managers do outperform their benchmark indexes, but very randomly.  Since there are so many active investment managers out there, there are always some who will outperform a benchmark index based on the law of large numbers.

The problem is that the managers who do are simply lucky.  It’s not due to skill, experience, or process, it’s luck.  Think about it.  If there are 10,000 active mutual funds out there, there have to be a handful that will outperform an index for five consecutive years.  And since it’s impossible to identify the managers in advance, Fama and French’s paper supports index investing.

 

Vanguard, 2013

OK, I realize that a Vanguard study on the effectiveness of active management might not be so objective.  Vanguard is the behemoth of index investing, so obviously they’re likely to lean away from active management.  Jack Bogle started the company in the 1970s, and pioneered mainstream index investing.  Even so, the people at Vanguard are very smart.  And their 2013 paper makes excellent points that seem unbiased.

The paper makes two different comparisons.  In the first, it compares the performance of actively managed funds to their benchmark indexes.  And in the second it compares the same funds to the performance of index funds that represent their benchmark, since in reality there are costs (albeit lower) when investing in an index.  And yes, the study found that index funds mostly outperform actively managed funds over long periods of time.

Interestingly, the paper also dug into survivorship bias in active management.  Survivorship bias is one of the main flaws of some of the earlier research in this area.  Simply put, most previous studies done on passive vs active investing didn’t include the funds that closed.

If you or I were to look up the performance of all actively managed mutual funds over the last 20 years, we’d get big long list of funds.  But what about the funds that closed back in 2005?  By omitting the funds that failed, you are only considering funds that have remained open throughout the entire period.  This skews the performance data upward.  Vanguard went back and included all mutual funds in their research to eliminate survivorship bias.  And when they did, it strengthened the case for index investing.

 

Morningstar Active / Passive Barometer

There are some researchers out there who think that the relationship between active vs passive investing changes with market conditions.  Morningstar dove into this with it’s active / passive barometer.

Every six months, Morningstar researchers take a look at how active funds have performed vs index funds over different time periods.  Since the barometer is updated every six months, Morningstar likes to use it more as a “running tally,” to test the changing market conditions hypothesis.

As of their most recent report, Morningstar’s research also favors index investing.  Looking at the most recent ten year interval, only 16.6% of actively managed large cap U.S. mutual funds have outperformed their index by enough to justify their fees.

An interesting finding from Morningstar’s paper is that an actively managed funds’ ability to outperform their benchmark is correlated to it’s fees.  Higher cost funds are more likely to underperform (or be closed or consolidated) than low cost funds.  Back to the large cap U.S. blend mutual fund category, 19.7% of low cost funds outperformed their benchmark over the last 10 years, while only 10.7% of high cost funds did.

 

Market Efficiency

The three studies I noted above looked at a very wide swath of mutual funds.  They all concluded that indexing is likely to outperform active management over long periods of time.  But when you break it down to specific asset classes, that’s not quite as true.

Both the Vanguard and Morningstar papers broke down their research by asset class.  Both found that active management was more likely to outperform in emerging markets than it was in U.S. markets.

And in 2012, researchers from UC Berkeley looked specifically at active management within emerging markets.  This paper found that active management outperforms indexing by up to 2.75% after taxes in emerging markets.

The reason?

Market efficiency.  Market “efficiency” refers to the way that new financial information is digested by investors.  And coincidentally, the efficient markets theory was developed by our old friends Fama and French from the study mentioned above.

Put simply, the U.S. financial markets are very efficient.  When a big company like Apple has major financial news, it distributes the news through a press release.  Seconds later, this information shared electronically and in the hands of every mutual fund manager in the world.  U.S. stock markets are considered more efficient than other markets around the world, because investors have somewhat equal access to information.  (Yes, there is some insider trading and other shenanigans that occur here and there.  Yes, some investors have better access to information than others.  But by and large, U.S. markets are pretty efficient).

What about the emerging markets in other places around the world?  What happens if a Brazilian oil company discovers that one of their rigs is partially damaged and their oil output will down?  That’s certainly information it’s investors will want to know about.  But will that update be distributed equitably like it would be in the U.S.?  Most likely not.

This isn’t to say that investment managers in the emerging markets are cheating, but it does indicate that it’s easier for active managers to gain an advantage in less efficient markets.  This idea is supported by the Berkeley, Vanguard, and Morningstar studies.  The less efficient a market is, the better chance active management has to work.

 

Applying the Research

Let’s summarize our discussion so far:

  1. Active management should only be used when the additional returns justify the additional cost.
  2. When we examine all actively managed funds, there are only a few that justify their fees over long periods of time.  Those that do are impossible to identify in advance.
  3. Active funds with low fees are more likely to succeed than active funds with high fees.
  4. Active management is more effective in less efficient asset classes.

 

Here’s What You Should Do With this Knowledge:

That is a whole lot of research we just went over.  I know it can be pretty dense stuff, so thanks for not tuning out.  As a reward, let’s discuss how you can use this information to your advantage:

  1. Use an indexing strategy in asset classes that are more efficient, like U.S. stocks
  2. Use an active approach in areas that are less efficient, like stocks and bonds in emerging markets
  3. Use a blend of indexing and active management for anything in between, like international stocks
  4. If you’re unsure, use indexing since it’s the less expensive option
  5. When you use active management, always, always, always choose lower cost funds

All in all, I’m a believer that active management is guilty until proven innocent due to it’s extra cost.  There are definitely areas where active management works, but before investing I’d need to see consistent returns (alpha) to justify the strategy.

 

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