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What’s Better, Active Or Passive Investing?

As an investment advisor, one of my most important roles is to educate folks about the facts and fictions of investing.

I recently received an email from a radio listener outlining concerns about her current investment approach. This listener had been using active mutual funds for years and wanted to rebalance her portfolio using passive investment vehicles. She said, “Wes, is it time for me to become a passive investor?” Let me try to answer her question because it likely applies to most of you at some point in your investment lifecycle.

Let me first help define active investing vs. passive investing.

Passive investing, by strict definition, entails 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. For all intents and purposes, there really is no such thing as pure passive investing, just various shades of active investing. More on this in a second.

For instance, if an investor chooses to hold the S&P 500 index fund, widely regarded as a passive strategy, that investor is actively choosing to hold only U.S. stocks. This is actually an active decision to only invest in about 10 percent of the world’s more than $240 trillion investable marketplace, which includes U.S. small- and mid-cap stocks, the U.S. bond market, international markets, etc.

Furthermore, any approach that uses multiple passive vehicles (index funds, ETFs, etc.) is, by nature, now an active strategy.

So the real genesis of the active vs. passive debate, and the question from our “Money Matters” listener, centers around performance. In short, which performs better? Is it true that the vast majority of active funds are bested by their index fund counterparts?

The real answer is that some do and some don’t. But it’s not nearly as one-sided as most headlines would have you believe. 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.

On the other side of the spectrum, 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 percent 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. This data is in stark contrast to the Standard & Poor’s study, mostly due to how each study categorizes funds that are no longer in existence.

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 the vehicles that we use as investors, and how our overall investment strategy or approach is 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.

Very few investors feel comfortable applying a fully passive investment approach. Simply investing in an S&P 500 index fund or one of the many hundreds of index funds that track indexes around the globe creates an uncomfortable “just live with it” approach.

Empirical data from Dalbar shows that the majority of individual investors have little tolerance for dramatic market moves, which leads to ill-timed buying and selling, otherwise known as poor “market timing.” Rarely have I ever met an investor that has just ridden out the full ups and downs of owning one index fund through an entire market cycle; the emotional reality of this approach is almost always too much to bear.

So 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, including our “Money Matters” listener, will benefit from a combination of low-cost active and passive vehicles. This confirms my long-standing belief despite heavy-handed arguments from both sides of the aisle.

 

 


 

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