Passive vs. Active Investing: Which is better?
14 Apr 2017
There is a debate that is live and well within the investing community. This is the Active vs. Passive Investment Management debate. So which is better for the average investor? Is it better to hire a professional manager to pick stocks and try to outperform the market? Or is it better to own everything and admit that no one an outperform the market as a whole? In order to answer these questions, I think it is necessary to understand and evaluate the merits of both arguments.
I like to use the analogy of two drivers heading down the interstate. The passive driver is going to go with the flow of traffic, regardless of the road conditions. They will speed up or slow down simply based upon what the other traffic is doing. If the traffic is driving 80, then so are they. If moving at 45, they will slow down as well. Conversely, the active manager will select their speed based on their personal observations of the conditions. Even if the traffic flow is going 70, they may decide that because of the recent ice storm, it is more prudent to go 45. On the flip side, they may still be going 45 during the summer when the sun is shining.
Passive Investing is just that. It is built on the idea markets are efficient, and that no one has an edge when it comes to information and price discovery. Investors are not trying to outperform a benchmark, they are only trying to mirror it. One of the upsides of this strategy is that the total cost to the investor is much lower as the investment simply mirrors the benchmark it is trying to measure. By purchasing something that mimics the benchmark, the investor’s return is not going to deviate a lot from it’s performance. Investors also can benefit from having a very diversified portfolio put together in this low cost structure.
If the markets do well over time, the assumption is that the investor will do well also. The drawback is when the markets have their inevitable pullbacks or draw downs. The client will have the same negative performance as the market as a whole. This could lead to negative emotional behavior, such as getting out of the market at the bottom, and getting back in after the recovery and when it is again perceived as “safe”.
On the flip side, Active Investing involves hiring a manager to invest the funds for you. This is predicated on a belief that the markets contain some inefficiencies which can be exploited by the skilled manager. The manager selects securities based on their belief of what is going to happen. They then use their skill and expertise to try and outperform their benchmark. Hiring a manager does come at a cost.
Typically, these types of investments have much higher fees when it comes to their passive counterparts. Another drawback is that the manager can be subject to the same emotional risk as an ordinary investor. This may lead them to make decisions based on how they are feeling, rather than relying on a process. One of the advantages though, is the ability of the manager to potentially mitigate some losses through a variety of techniques. Depending on the type of fund, they may move to cash depending on market conditions. They may also rely on more sophisticated strategies such as stop losses and hedging options.
Two Different Styles
Clearly each style has their own advantages and disadvantages. So how do we determine which one is the best for the average investor? According to a 2016 Hartford Whitepaper on the subject, out performance of active vs. passive styles typically occur in cycles. This means to say that sometimes active managers outperform, and sometimes passive styles outperform. According to the authors, looking back to 1985, there have been 15 years of active out-performance, and 15 years of passive out-performance. Over the 30 year time frame of 1985 to 2015, the relative out-performance of each strategy was cyclical.
If there is a cyclical nature to out-performance, relying on one strategy over the other might not be the best path forward. By combining the two into portfolio construction, an investor may be able to take advantage of the benefits to both. The investor may be able to take advantage of a skilled manager, while simultaneously lowering the total expenses on a portfolio using a passive approach.
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When Active is not Active
There is a danger lurking in active funds though. All managers are not created equally. These are what the industry has dubbed the “closet indexers.” These are fund managers who in their attempt to keep relatively the same performance as a benchmark, select holdings that are mostly similar. They only deviate a little bit, trying to just beat the index, and thus prolong their careers as a manager. In this case, the investor is receiving the performance of a passive investment, with the expenses of an active manager.
Enter the concept of “Active Share.” This is a measure of holdings in a portfolio that differ from the index. Managers with high levels of active share are not mirroring their comparative index. They are selecting securities and weightings that are held outside of the index in an attempt to have performance that differs from the market overall. Depending on the strategy or process used, they could hold many individual securities, or just a handful.
The average investor would be wise to determine what their goals and objectives are prior to investing. If the goal is to create a very diversified, low cost portfolio, a passive strategy may be the way to go. If they are looking for a specific objective or return, then finding an active manager that attempts to provide this could be the best route. Another alternative is to combine the strategies and take advantage of the synergies that can be provided. The challenge though is to evaluate whether or not an active manager is truly active, or simply an index in active clothing.
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