Active vs. Passive Investing: Does it Have to be a Case of One or the Other?

Active vs. Passive Investing: Does it Have to be a Case of One or the Other?

As published in the Holiday 2014 Edition of NJ Lifestyle

Much is written in the investment world about active vs. passive investing. It probably makes sense to define both before continuing to address the argument for one over the other.

Passive investing (also called passive management) is a financial strategy in which an investor (or a fund manager) invests in accordance with a pre-determined strategy that doesn’t entail any forecasting (either market timing or stock selection for example). The idea is to minimize investing fees and to avoid the adverse consequences of failing to correctly anticipate the future. The most popular method is to mimic the performance of an externally specified index. Active investing is just the opposite.

Active investing (also called active management) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index. If an investor wants to invest in US Large Cap “blue-chip” stocks, a passive investor might buy a fund that mimics the S&P 500 (an index that represents 500 large US companies). An active investor will try to select a sample of large cap domestic stocks with the goal of achieving a higher return than the S&P 500 after fees and expenses.

Proponents of passive management will often cite various statistics about how few active managers beat their benchmarks. Dimensional Fund Advisors (“DFA” funds, an investment manager that specializes in index and enhanced index funds) indicated in their research that 81% of active equity mutual fund managers failed to beat their benchmarks over the ten year period ending 2013, meaning only 19% of active managers were able to outperform. Furthermore, only 52% of actively managed equity mutual funds were still in existence at the end of the same 10 year timeframe, highlighting the difficulty in selecting an active fund that will not only survive, but outperform as well. Proponents of passive investing will also cite low fees and tax efficiency in index products as other reasons passive investing is superior to active. Index funds like DFA US Large Company (with an expense ratio of 0.09) or Vanguard Dividend Appreciation (with an expense ratio of 0.10) provide extremely low-cost access to US blue-chip stocks and have had five year average returns of 16.6% and 14.8%, respectively.

Critics of passive investing will cite passive investing’s inability to adjust to changing market conditions. As an example, in May of 2013 when interest rates started to rise, investors who owned Vanguard’s Total Bond Market Index had no way to counteract the loss in value because as an index fund, this fund would own the entire bond market and not have the ability to address concerns around interest rate risk. Investors could have benefitted from moving to an active manager, such as the Goldman Sachs Strategic Income fund, which was able to capitalize on many of the opportunities in the bond market such as shortening duration and shorting long-term treasuries. This active strategy was able to gain 4% over the rest of the year, while the passively managed bond index dropped 2.14%.

Proponents of active management cite the abilities to outperform their benchmarks and to adjust to changing market conditions as key reasons to favor the strategy. They will also take statistics cited above and say yes, 81% of active managers are unable to beat their benchmarks over ten years but if you can find the 19% that do, you are better off. Two active large cap growth strategies such as the Fidelity Contrafund and Amana Growth, have 10 year average returns more than 2% better than their S&P 500 benchmark. Our philosophy regarding active management is that our active managers have to earn their fee by beating their benchmark more often than not. When that doesn’t happen, the manager is terminated.

At CRA Financial, we don’t believe investors have to decide on either active or passive investing. Rather, we believe there is real value in selectively building and investment strategy that utilizes components of both the passive and active philosophies. When looking for low cost exposure to a broad asset class, we will often use index funds like DFA or Vanguard to create a core holding in a portfolio. When looking for expertise in a particular asset class or flexibility to adjust to changing market conditions, we will introduce active strategies to our allocations as satellite positions around our core index products.