Active Investors vs Passive Investors

In theory there are some massive advantages for active investors compared to their passive counterparts, but it’s whether or not these theoretical advantages translate into reality that matters.

A passive approach

Passive investors sit back and let their investments do the work for them without interfering.

There’s no reason why you couldn’t do this with most types of investment, but passive investors have become synonymous with cheap diversified index investing.

The theory being you invest in a low cost fund that tracks a market index. In other words, you simply go with the market, and going with the market turns out to be a great thing to do because it has treated investors extremely generously in the past.

Essentially, the idea is that passive investors don’t know which stocks are going to do well so they just buy as many of them as possible. By doing this they acknowledge that they will own some clangers but also believe that the top stocks will more than make up for poor performing stocks because historically that has been the case.

If you believe business is going to grow, investing in the shares of as many businesses as you can seems like a great idea, and importantly, this investing approach has been proven to work, it requires next to no work, is tax efficient and cheap. It’s no wonder it is becoming more and more popular by the day.

The advantages of passive investment

• Low cost
• Tax efficient
• Easy
• It works

Historically passive investing in the UK and US has provided returns of around 10%. Not bad considering you hardly had to do anything, but not good enough for everyone.

Which brings us to active investors.

Active Investors

Active investors set out to beat the market.

There are all kinds of active investors out there. But, perhaps, the most active investors of them all are traders.

Whereas passive investors are looking for bigger profits over the long term traders look to take smaller profits over the short term.

Traders are more likely to use increasingly complex trading techniques such as short selling, stop-loss orders, and leverage. They also tend to use more types of security. Perhaps the most obvious one being currency, commonly termed forex or FX.

Using lots of trading instruments and more complex techniques allows traders to try to make money in rising and falling markets.

Traders make decisions which they hope will improve their investment returns. These decisions may be based on what is going on at a particular company, they could be based on what’s going on in the global economy, or they could be based on chart indicators.

They may buy gold because they think we are heading for a recession or chart indicators may cause them to short sell Google.

In any case, they want to provide higher returns than the wider market.

Generally traders fit into four groups: position traders, swing traders, day traders and scalp traders, depending on how long they hold their positions for.

These groups and the typical times they hold positions for are shown in the table below:

Different types of trader

Type	Time investments are held for
Position	months to years
Swing	days to weeks
Day	hours
Scalp	seconds to minutes

Traders in the UK typically use platforms that offer contracts for difference (CFDs), which describe an arrangement where one party agrees to pay the difference between the value of a security at the start and end of a contract.

In reality from the traders standpoint they can work just like standard investing. You buy a stock CFD from your broker and if it goes up you make money, but if it goes down you lose money. The key difference with a CFD is that you didn’t really buy the stock, you just profited (or suffered a loss) from the price movement.

Lots of traders like CFDs because they offer a much wider collection of products to trade, more advanced trading such as shorting, stops and limits are easy to carry out and often cheaper than with more traditional brokers.

But perhaps the biggest draw is the fact that it’s much easier to use leverage. In other words there’s nothing much stopping you from using borrowed money to trade.

Borrowing money makes money

Using leverage is risky, but at the same time, it’s a powerful way to increase your gains. If you buy a £100 CFD and it goes up 10% you’ll have £110, but if you leveraged 10/1 i.e. you borrowed £900, you’d have £200.

Using leverage has doubled your initial £100. Of course that’s great when things go your way, but not so great when they don’t.

Leverage rules change all the time, but last time I used a CFD broker you could easily leverage 30/1.

Think how good you’d feel if you pulled off a 30/1 trade. But at the same time think how dangerous that would be if the trade went against you. It’s no wonder some people lose a lot of money using CFD platforms.

Traders are an extreme form of active investor, but active investors don’t have to be so active.

The minute you move away from the wider market you take an active approach. Picking an individual stock, even if you simply buy and hold is an active decision.

Allocating more of your money to a particular sector or country is an active decision. In fact, it is my guess that people make active decisions all the time without even thinking about it.

The advantages of active investment

So on paper active investors and traders have lots of key advantages:

• They can borrow money to increase returns
• Use complex trading techniques
• Make money in a down market
• Use lots of different trading instruments
• Use specialized equipment and software

The reality

In theory active investing sounds good but in practice it doesn’t seem to pan out.

Let’s start with traders. We’ve already established that traders like CFD platforms, which in the UK are called spread betting platforms. The clue is in the name. It’s more of a bet than an investment.

The Financial Conduct Authority studied spread betting and found that 82% of spread betters lost money using CFDs.

In fact, this is pretty much in line with a study done by Barber, Odean, Lee and Liu that investigated the performance of day traders in Taiwan from 1992 until 2006.

They found 80% of day traders lost money, and of the 20% left over, only 1% of them were able to outperform consistently.

Lots of people I talk to aren’t surprised by that. They assume trading is difficult, which is why they pass their hard earned savings on to fund managers.

Like many aspects of life, if you don’t know how to do something it makes sense to pay for a professional to take care of things on your behalf.

Professionals

Professionals are trained in what they are doing, they use the latest technology, pay for access to the best research, and most importantly spend all their time on it.

If for no other reason, you’d think the high fees financial professionals charge would all but guarantee beating passive investors and their index funds, but unfortunately they don’t.

In fact, even the greatest professional investor of them all Warren Buffett recommends taking the passive approach and choosing an index fund. He 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.

Warren Buffett

S&P Dow Jones Indices

There are many studies that back up Buffett’s words but perhaps 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 capitalization of 500 large US companies. It’s considered one of the best indicators of the state of the US stock market.

In their SPIVA Year-End 2017 report S&P Dow Jones 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, and 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.

S&P Dow Jones

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.

In other words, if you invest passively through an index fund, your fund would beat most active fund managers.

How can this be?

It seems counter intuitive that active investing seems to underperform the wider market, but when you stop to think about it, it starts to make sense.

You have two fundamental choices. Buy all the stocks or just buy some of them i.e. the ones you think are going to outperform.

Now stocks don’t float around on their own. All of them are owned by someone.

If you don’t buy all the stocks, then the stocks you don’t buy must belong to somebody else. The law of averages means one of you is going to do better than the other one. It’s just the nature of things.

Based on that logic, there’s bound to be fund managers that do better than others. Basically, all the stocks are divided up between all the fund managers.

When great returns aren’t what they seem

Some of them beat the market and some of them don’t. It should follow that you’d have a 50/50 chance of picking a fund manager that outperformed the market, but you don’t, because lots of the funds that outperform, only outperform by a small amount, and that small amount doesn’t even cover their fees!

Think about it, these fund managers have to research companies, keep up to date with the latest economic changes, buy lots of fancy technical equipment, read lots of subscription journals and pay for their bespoke suits.

If your fund manager beats the market by 1% a year but his fees are 2% a year, you’ll end up losing out.

Even talented investors that do it themselves and so don’t have fund fees to consider are still handicapped by other fees.

Anytime you buy or sell a share it costs money. In the UK you’ve got commissions and stamp duty to pay at the very least, which is bound to impact your results more than if you invested in a simple index fund.

Unlike individual shares index funds don’t have stamp duty to pay, and many brokers let you invest in them commission free, and even if you they don’t, and you have a commission to pay, index funds enable you to buy shares of lots of different companies for a single commission.

The bottom line

In theory there should be many advantages for active investors compared to those who take a passive approach.

But only 1% of traders are able to outperform consistently and only 1 in 20 funds taking an active investing approach manage to beat their corresponding index funds over the long term.

The bottom line is passive investors usually do better than active investors, so most investors are going to be better taking a passive approach.