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
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.
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.
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.