Active Investing vs Passive Investing
Nobody wants to be passive in anything they do. This includes in the field of investing. This is magnified when you have an active alternative you can choose.
Surely they are incomparable.
Active investing involves picking stocks or funds, deciding how much to invest and when to invest. The investor can be active themselves or they can invest their money in an active fund.
Active funds are usually looked after by an active manager, although in some cases active managers are being replaced with algorithms, sometimes called robo-advisors. You can read more about robo-advisors here.
This manager, whether human or robot has a very straight forward objective: provide higher returns than the competition when the market is going up, and lower losses when the market is going down.
Passive Index Funds
On the other hand passive funds simply go with the market, by following an index. These days there are a multitude of indexes, but perhaps the most famous one in the UK is the FTSE 100. A list of the UK’s top 100 companies by Market Capitalization (Market Cap).
Market Capitalization is a way to determine a company’s size based on the total market value of a company’s shares. Many of the biggest indices use this approach. How much of company to invest in, is determined by the size of the company. As a company’s size (by market cap) increases, so does the percentage of funds invested in that company.
For example, passive funds following the FTSE100 simply mimic the stock sizes of the index in proportion. If the FSTE100 has 2% of its investment in Shell, then so will the passive fund. If HSBC grows to 2% from 1%, the fund will buy more HSBC shares to make sure it has the same proportions as the index.
Because passive funds simply follow an index, the amount of work required is reduced. As a result, this usually enables passive funds to keep their prices really low.
Those in favour of active investing argue only this method gives you a chance to beat the market. Those in favour of the passive approach point out that the evidence suggests that simply isn’t the case.
S&P Dow Jones Indices
There are many studies which show that fund managers usually under-perform their benchmark, usually an index. Some of the most prominent research in recent times has been carried out by S&P Dow Jones Indices.
S&P Dow Jones Indices should know a little bit about an index. They produce, maintain, and license many stock market indices. They are best known for the S&P 500 and Dow Jones Industrial Average (DJIA).
The S&P 500, often just called the S&P, is perhaps the most famous index of them all. It is based on the market capitalizations of 500 large US companies. It’s considered one of the best indicators of the state of the US stock market.
The DJIA is perhaps the second most famous index. It is a little different from the S&P. Firstly, it contains just 30 large public US companies, and secondly its value is not based on market cap. Instead, it is based on the sum of the price of one share of stock. It was created way back in 1896.
Research
S&P Dow Jones Indices recently released its SPIVA Year-End 2017 reports. In this report they compare how their indices compare to those funds which take an active investing approach. They have lots of different indices in lots of different countries, but the biggest one that everybody looks at is the one for the US. It makes for very interesting reading:
“Over the 15-year investment horizon, 92.33% of large-cap managers, 94.81% of mid-cap managers, and 95.73% of small-cap managers failed to outperform on a relative basis.”
That’s basically saying that over the last 15 years only about 1 in 20 funds taking an active investing approach have beaten their corresponding index funds. Whichever way you frame it, that doesn’t look good for active investing.
Though 1 out of 20 aren’t great odds, passive investors must admit the 1 in this research does show some fund managers do actually out perform the market. In fact, it could be argued that big names in investing like Warren Buffet prove the market can be beaten.
Having said that, Buffet himself recommends choosing an index fund and says:
“It will do better on balance than what they (investors) will get if they go to professionals, because the professionals, after fees, don’t know how to get a better result.”
Even if you think active managers can outperform the market, here’s one way to look at it:
Option 1 – Active investing – 1/20 chance of winning, expensive;
Option 2 – Passive investing – 19/20 chance of winning, cheap.
By now active managers must be questioning their very existence!
It is worth pointing out that passive investing basically means you don’t do anything. As a result we could frame this research yet another way:
Option 1 – Active investing – 1/20 chance of winning, expensive, requires lots of hard work, resources, people, and equipment;
Option 2 – Passive investing – 19/20 chance of winning, cheap, don’t need to do anything!
It wouldn’t be fair to overlook the fact that over a shorter time period of 1 year, more active managers beat the market. However, here’s what Ryan Poirier, senior analyst at S&P Dow Jones Indices, has this to say about this:
“If you have an active manager who beats the index one year, the chance is less than a coin flip that the manager will beat the index again next year.”
At the end of the day, there are people out there, like Buffet who have consistently beaten the market. Some investors will be confident in their own active investing abilities. Other investors will be confident they can find a fund manager with the necessary skills.
For the majority though, the research indicates both of these options are extremely difficult to do successfully. It is therefore difficult to argue against a passive approach for most investors.
