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Choosing Active vs. Passive Investments

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Within the financial services industry a great debate rages over active management vs. passive management — two different types of investing styles.  Active management is the art of stock picking and market timing.  Active managers focus on identifying and buying securities that are either “undervalued” or “overvalued” and trying to outperform or beat the market (usually defined as the S&P 500).  Bill Miller, the manager of Legg Mason Value Trust, is an example of an active manager and many people are familiar with his track record of beating the S&P 500 Index for fifteen straight years.

Passive management is most often characterized by index funds and Exchange-Traded Funds (ETFs).  Passive managers attempt to replicate stock market indexes by purchasing the stocks that compose them.  The goal is to attempt to match market index returns rather than achieving outperformance.  For instance, if the S&P 500 Index returns 10% in a given year, an S&P 500 Index Fund will attempt to match this return as closely as possible, minus expenses.  John Bogle, the founder of Vanguard Investments, is probably the most well-known proponent of the passive investing style.  Bogle created and introduced the first index fund, Vanguard 500, in 1976. The argument for passive management is based upon the efficient market theory which postulates that market prices reflect the knowledge and expectations of all investors. This theory asserts that any new development is instantaneously priced into a security, thus making it impossible to consistently beat the market.

The chart below provides a basic comparison of these two styles of investing:

So which style is best?  Academic studies and real world experience show that active managers have a hard time consistently outperforming market indexes, in large part because of the high expenses (some which are disclosed to the investor and some which are not) associated with active management.

For instance, turnover occurs whenever a mutual fund buys or sells the underlying securities within the fund.  The fund pays transaction fees which are known as “trading costs” and these fees serve to reduce the investors’ return.  Unfortunately, trading costs are not disclosed to investors.

On average, a fund with a 100% annual turnover loses nearly 1% in trading costs (1). William Harding, an analyst with Morningstar, says the average turnover ratio for managed domestic stock funds is 130 percent (2). If a mutual fund manager turns over the portfolio 130% each year, investors are paying roughly 1.3% in trading costs in addition to the fund’s expense ratio (3).  Things are not always what they seem in the financial services industry.

Actively managed funds generally have higher turnover which leads to high trading costs (often dramatically higher costs) and make it even more likely that an actively managed fund will fall short of its benchmark.  In contrast, passively-managed funds typically have much lower explicit costs (i.e. expense ratios) as well as implicit costs (i.e. trading costs).

The study referenced below (4) shows that only 2.5% of 355 mutual funds outperformed the S&P 500 Index during the period from 1970-2000.

 

Studies like these illustrate that it is not only difficult for an active manager to outperform their benchmark index any given year, but over longer periods of time, the case for passive management becomes even more compelling.   The main reason for this phenomenon is there is no reliable way to determine which active managers will be amongst the small number who will outperform in future years (i.e. past performance has no correlation to future results).  It doesn’t necessarily mean that no one can pick winning stocks; just that it is a very rare skill that is almost impossible to identify in advance.

As an investor, you will probably do far better over time (and at a much lower cost) by investing in a diversified portfolio of index funds rather than trying to select which actively managed funds will prevail each year.  It is recommended that a healthy dose (or more) of your investments be in passively managed strategies.

(1) Mark Carhart. “Persistence in Mutual Fund Performance,” Journal of Finance March 1997. Co-chair of

the quantitative research group at Goldman Sachs

(2) http://www.bankrate.com/brm/news/investing/20020306a.asp

(3) Matthew D. Hutcheson. “Uncovering and Understanding Hidden Fees in Qualified Retirement Plans
2nd Edition – Published February 1, 2007″

(4) Source: “Dead Funds and Return of Surviving Mutual Funds Relative to the Market, 1970-2000 (31 years)”- CRSP

The information in this article is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, and does not purport to be complete and is not intended as the primary basis for financial planning or investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

07/20/2011 Tagged ,


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