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Active vs Passive Investing: Which Option Is Best?


A common debate between investors remains the argument between active vs passive investing. Both methods have staunch proponents who perhaps stubbornly refuse to see the merits of the other approach, and ultimately cost themselves potential returns.
While passive investment has become popular in recent times, there are distinct advantages to active equity management. These respective advantages and disadvantages of each method, will be discussed below.
This article will also break down some of the differences between the two strategies to help investors decide which approach better serves their short and long-term goals. Read on to learn more.

What is Active Investing?

Active investing involves continuous buying and selling in an attempt to maximize profits. Investors and account managers who choose to actively invest continuously monitor the market or markets for potentially profitable situations, and seek to exploit market anomalies whenever possible.

When people hear the term “stock trader,” this is the form of investing and account management that they likely envision.

Rather than buying into an index and letting the market play out, active traders locate equities that they believe will increase in value in the near-to-moderate future and invest into individual equities somewhat heavily.

While smart active investors still practice diversification in investing, their portfolios (or their managed portfolios) will not include the diversity of an index investment.

What is Passive Investing?

Passive investing is an approach in which investors maximize their eventual returns by keeping buying and selling to a relative minimum. The most-popular forms of passive investment today are likely mutual index funds and mutual funds.

One of the reasons that this type of investment has become so popular is that investors are still seeing strong returns while reducing management fees. Because index investing is designed to mirror a given market, managers are not constantly buying and selling equities, and investors realize significant savings in this regard.

For those who do not love scouring market reports for the latest changes, passive investing can certainly be an effective way to supplement income.

Active vs Passive Investing Arguments

The respective arguments for active vs passive investing are well-established, but will be presented here for readers to weigh.

Those in favor of passive investment argue that investors should buy and hold since over the last 100 years, the stock market has actually rallied steadily. They favor passive investment because they believe in the market itself, and feel that over the long-term the market will produce returns for those who buy into it.

Moreover, the specific returns match the benchmark that an investor follows. In the case of a strong index such as the S&P 500 index, passive investors like to note that their technique incurs much lower management and associated fees. By buying into such a large basket of stocks, index investing typically doesn’t miss out on any big winners.

That said, passive investment isn’t an absolute no-brainer. Those who favor active investment approaches first point out that there is no downside protection with passive investing.

In fact, many investors who primarily buy into passively-managed indices have hedged by migrating to actively-managed exchange-traded funds (ETFs). This is because rising interest rates and additional market volatility have inspired investors to move away from pure indexing, and to reconsider the merits of active management.

This is one way in which passive investors can provide themselves with a bit of downside protection, though some investors flatly refuse to participate in actively-managed investments or funds.

Moreover, a protracted bear market can cut a pure index investor’s account in half, or perhaps even less. This is as strong an argument for diversification as any exists, even if the returns from pure indexing and passive investment are ordinarily solid.

The Data on Active vs Passive Investing

It’s clear there is a philosophical divide concerning active vs passive investment. Some investors will always feel that buying into a bigger basket of stocks or bonds is a better strategy than focusing on individual equities. While active managers rightly feel there are advantages to discretion and a research-based approach.

Rather than continue to debate between two sides with respective merit, perhaps it’s best to consider the available data on both passive and active investment techniques.

To begin, studies on the two approaches are wildly inconsistent, which no doubt leads to additional arguing between the two camps.

Drawing Data from a Morningstar Study

For example, Morningstar drew a number of conclusions from their study on active vs passive investment. Here are the four key takeaways from the study:

  • 43% of active managers in 2017 outperformed their passive-managing peers, up from 26% in 2016. Per this study, active investment management appears to be on the upswing.
  • This effect was most pronounced with small-cap stocks. Active managers outpaced passive managers by 48% in the small-cap category for 2017. This makes a lot of sense, as the indiscriminate nature of index investment is apt to overlook winners and stick with declining small-cap stocks until they fall off a given index.
  • Value managers – meaning those who primarily scout mid-cap stocks with intrinsic value unseen by most of the market – also saw big increases in performance from 2016 to 2017, averaging increases of up to 33% greater than the preceding year.
  • Lastly, active bond fund managers outperformed passive fund manager by 61.4% for the year. Bonds on the whole did very well for 2017, with intermediate-length bonds being the only category to see a decline. But it’s worth noting the performance gap between active vs passive investing.

Overall, the key conclusion from the Morningstar research is that while passive investing may still be slightly outperforming active investing, the latter method is making a strong comeback.

This data obviously comes from the 2017 fiscal year, and perhaps the 2018 data will offer different guidance after it’s interpreted. But the available data suggests that while both forms of investment have merit, active investment should be used in select situations, at the very least.

Comparing Fund Managers with Benchmark Indices

Other studies are all over the map. Some studies compared fund managers with their benchmark indices, while others compared funds with broad market indices.

Further complicating matters is the fact that investors and researchers can disagree over what constitutes an active manager. These definitions vary so much that it makes interpreting the data difficult.

Some studies use differing time periods to state their performance claims. But many of these studies are not in-depth, with most just comparing mutual funds and ignoring investments such as separately- managed accounts.

Finally, data comparing bonds and bond fund performance is very seldom explored. Companies that manage or run index funds tout the advantages of the passive process without detailing the disadvantages, while brokerage and investment advisory firms do the same.

Two Points to Consider

There are two points that most available studies on active vs passive investing could confirm:

The first point is that beating indexes over time is difficult, but not impossible, for a majority of fund managers. A bias in the data collection is that most studies almost all examine fund managers only.

The second point is that active investing seems better suited to bear markets. Active managers have the latitude to react to risk, and to jettison poor performers during bear markets. Active investing also seems to work better in value and sector investing.

But even formal studies dedicated to finding the truth in the active vs passive investing argument come up a bit short. There are simply too many variables at play – to say nothing of ego and money-motivated bias – to get an accurate bearing on which approach is ultimately superior.

So, it’s incumbent on every investor to consider the pros and cons of each approach, and to decide for themselves which way to lean. Moderation, and using a combination of the two approaches, seems to be the smartest advice for most situations.

Active vs Passive Investing: Choosing the Best Approach for Your Situation

There are plenty of merits to both active and passive investing. Both forms of investment have shown the ability to produce excellent returns when implemented properly.

Active investing works well as a targeted approach, particularly for finding intrinsic value in underappreciated stocks and going heavily into winners or stocks set to explode. An active approach also helps investors slough off failing small-cap stocks that come as a part of an index investment.

Meanwhile, passive investing lets investors sample a basket of different stocks across numerous sectors and industries, while also letting investors ride high with the market. The minimal account and management fees associated with passive investing also help investors realize a more-immediate net profit.

At the end of the day, the type of investing that works best for you will likely come down to your investment experience, the amount of money you’re willing to spend on account servicing, and perhaps even your disposition. Passive investing will be too boring for some types, while active investing will be too risky for others.

The best advice is likely to use both methods to maximize your returns, as both approaches have proven to be money-makers when used situationally or tactically.

Linden Thomas & Company

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At Linden Thomas, we believe most indexes focus on the wrong things like weighting the index based on the size of a company (market cap).

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