Active vs. Passive Investing
The debate of active investing vs. passive investing debate has raged on since Vanguard introduced its first index fund in 1975. In this post, we will review the key distinction between active and passive investing, delve deeper into each approach, review the record of active vs. passive, and analyze common critiques of passive management.
Active vs. Passive Investing
The key distinction between active investing and passive investing is how these strategies attempt to perform relative to their stated benchmark or "index." Active investors attempt to outperform the index. Passive investors attempt to match the index. This is why passive investing is also called index investing, and passive funds are also called index funds.
The index is the proper comparison point for your investments. In their prospectus, mutual funds and exchange-traded funds (ETFs) are required to state the benchmark they are attempting to outperform (in the case of active managers) or match (in the case of passive managers). You will also often see this benchmark for comparison purposes when reviewing performance on the fund's website.
Funds will select an index based on the types of investments or securities the fund is trading in. For example, a fund that will hold primarily U.S. Large Cap stocks may use the S&P 500 Index or Russell 1000 Index as a comparison point. A fund that holds emerging markets stocks may use the MSCI Emerging Markets Index. And a fund composed of U.S. investment-grade bonds may use the Bloomberg U.S. Aggregate Bond Index as its benchmark.
By examining the stated index of a fund, you can understand the assets the manager is likely to invest in and expected returns and risk.
Evaluating Passive Funds
As described above, passive investing seeks to replicate or track a stated market index. Measuring the success of a passive fund is therefore pretty straightforward. A passive fund should very tightly track the performance of its stated benchmark in terms of return and risk. The return of a passive investment in any given time period should be very, very close to the return of the index, less fees charged by the fund.
For example, the SPDR S&P 500 ETF (Ticker: SPY) is an ETF tracking the S&P 500 Index (a proxy for U.S. Large Cap stocks). In the 10 years ending March 31, 2022, SPY returned an annualized 14.50% and the S&P 500 Index returned 14.64%. This annual difference is very close to the fees charged by the fund: 0.09%. And if you drill into shorter time periods, the performance for the fund and the index are also very close, as you should expect from a passive investment.
In reviewing a passive investment, if you see significant deviations from the return of the fund compared to its benchmark that are unexplained by fees, this is a red flag.
Evaluating Active Funds
While passively managed funds seek to track their indexes as closely as possible, actively managed funds seek to outperform their indexes by making "active" decisions. These decisions may include omitting certain index securities entirely or choosing to overweight (own more of) or underweight (own less of) certain securities in the index.
Again, these funds should be compared to their stated benchmarks in terms of returns and risk. But the evaluation is less straightforward because active managers, even those with the same stated benchmark, can have vastly different strategies and expectations.
For example, two managers both using the S&P 500 as their index may use very different strategies, leading to very different expectations for their returns and risk.
- One manager may employ a "high conviction, concentrated strategy" where they hold 30-50 stocks included in the S&P 500 Index. An investor in this fund may expect more ups and downs in this investment and significant differences in performance compared to the index as this fund is far less diversified than the index itself.
- Another manager may employ a "diversified" approach with modest "tilts." This manager decides holds all of the S&P 500 Index stocks, but chooses to overweight certain stocks and underweight others relative to their weight in the index. An investor in this fund may expect returns and risk much more similar to the S&P 500 with only modest deviations compared to the index.
Both of these managers hold U.S. Large Cap stocks and use the S&P 500 Index as their benchmark, but will likely perform very differently.
In addition to relative performance of active funds compared to their benchmarks, the risk and consistency of these funds must also be evaluated. Common statistics used to evaluate active funds include:
- Standard Deviation - a measure of the volatility, or magnitude of ups and downs, of the fund's returns
- Sharpe Ratio - the return of the fund relative to its volatility (standard deviation)
- Max Drawdown - the greatest peak to trough decline of the fund
- Sortino Ratio - the return of the fund relative to its downside volatility (downside standard deviation)
Which is better: Active or Passive Investing?
It would make sense that "active" management would outperform "passive." I once thought I might be able to make a good living in the market because I saw myself as a fairly intelligent and analytically-minded person. And if it turned out I couldn't pick the best stocks, at least I could identify the best managers who could consistently outperform market indexes. However, active management has consistently underperformed its passive counterparts and I've long since changed my tune.
Multiple recurring studies and publications underscore the difficulties of active management. Morningstar's Active-Passive Barometer is released semi-annually. Some key findings from the most recent publication, released February 2022, include:
- The percentage of active managers outperforming the benchmark over short (1-year) time periods falls dramatically as the time period lengthens. For example, 41% of U.S. Large Blend Stock managers outperformed their benchmark in 2021, but only 9% outperformed over the last 20 years. 69% of Intermediate Core Bond managers outperformed in 2021, but again only 9% outperformed over the last 20 years.
- Less than one third of U.S. Large Cap Blend managers survived the 20-year period ending in December 31, 2021. 42% of U.S. Mid Cap Blend managers survived the same period along with 51% of U.S. Small Cap Blend managers. This contributes to "survivorship bias," or the fact that the actively managed funds you see today are only the fraction of the funds that existed a decade ago.
- Cheaper active funds had significantly higher success rates compared to their more expensive peers, suggesting fund expenses are a valuable consideration in selecting active managers.
SPIVA also provides ongoing analysis of active managers around the world. SPIVA's persistence scorecard is insightful as it reiterates the consistency, or lack thereof, of active managers' outperformance. Unfortunately for those trying to find the best active managers, outperformance seems fleeting and is not a reliable predictor of future performance.
Active managers have generally underperformed their passive peers and odds are against investors expecting to outperform the market.
Why has Passive investing outperformed Active investing?
With so much at stake, investment markets are incredibly competitive. Active managers are competing against one another - with their research staffs, supercomputers, and decades of experience - to identify and take advantage of undervalued securities. The actions of these active managers, buying and selling and setting prices in the marketplace, make the market incredibly efficient and difficult to outperform. And here-in lies the brilliance of passive investing.
Although it's called passive investing, I believe the "passive" moniker massively obscures the research and efforts supporting these passive funds. Passive funds take the collective knowledge of the market (including all those active managers competing against one another) and passive funds use that information to construct their holdings. Passive funds essentially take a free ride on all the research efforts of the active managers attempting to outperform the market. And by replicating the index, passive investments can minimize costs like expense ratios (fees), trading costs, and taxes.
Active managers are competing against one another for those extra couple percentage points (or less) of performance. And after all this effort, they must account for their research staff salaries, overhead, etc. and pass these costs through to the investor through higher fees. More active trading also increases trading costs and taxes. These costs contribute to the exceedingly poor record of active funds compared to their passive counterparts.
Common criticisms of Passive Investing
Criticisms of passive investing abound and have been around since passive investing was introduced by Vanguard in the 1970s. However, the data supporting passive investing has little changed and most arguments against passive investing aren't compelling. Common criticisms of passive investing, and counterpoints, include:
Passive investing has grown too large and will now underperform active investing
Passive mutual funds had grown to nearly 40% of the mutual fund universe as of 2019, with projections of passive surpassing the share of active funds by 2025. The 40% figure is a massive increase from the 20% share of passive funds in 2010. Given this rise in passive investing, critics argue markets are growing less efficient and active managers have a greater likelihood of outperforming. But this depends on which active investors are dropping out of the market.
Less skillful investors dropping out of the market and poor-performing funds closing would lead to a smaller cohort of more skillful investors competing against one another, making the market even more efficient and difficult to outperform. So long as there are active managers trading in the market, price discovery and market efficiency is present.
Even though passive investments may have a large share of the dollars invested in the market, passive investments do not constitute the majority of trading volume. Active managers continue to make the lion's share of trades. A 2018 Vanguard study found passive funds account for only 5% of trading volume. So there is still plenty of price discovery and competition to find the correct price for securities.
Passive investing will underperform in bear markets
A commonly cited reason for using active management is that active managers will be able to better navigate bear markets and downturns. However, this doesn't show up in the data. In a paper from the Chicago Booth school reviewing mutual fund managers during the COVID-19 pandemic, researchers found "between 60 percent and 80 percent of active managers lost money on a risk-adjusted basis relative to their passive benchmarks."
You get what you pay for
Passive funds are relatively cheap, especially when compared to their active peers. According to Morningstar, asset-weighted average fees for active funds in 2020 was 0.62% compared to 0.12% for passive funds. Critics of passive funds will say you get what you pay for and active managers are well-worth their higher fees, but we have already seen that is not the case.
Not only have active managers generally underperformed their passive counterparts, cheaper active funds have generally outperformed their more expensive active counterparts!
Should you choose passive or active investments?
Despite the overwhelming evidence favoring passive over active investments, the "correct" decision ultimately comes down to what you are most comfortable with. Passive investments have overwhelmingly outperformed active managers, and I expect that to continue. But many investors prefer to see active managers at the helm or individual stocks in their portfolio. In addition to evidence and theory, your personal preferences must be considered in making this decision. As with so much in personal finance, this decision is ultimately personal and must heavily consider which strategy you will be most likely to stick with over the long run.