The Active vs. Passive Investing Debate
In one corner, we have actively managed funds, the traditional investment choice of generations. In the other corner, we have passive funds, whom have grown exponentially in popularity over the past decade and a half. With Warren Buffet winning his much-publicized bet with Hedge Fund Manager Ted Seides, it seems like the debate should be over, but is it? Here are some things to consider when choosing between active management vs passive management.
What is a Passive Fund?
Passive funds are typically index mutual funds. They get their name because they track a specific index, such as the S&P 500 Index. Index funds are considered passive because they are not trying to beat a particular index they are tracking, but they look to mirror its performance. An example of an index fund would be the Vanguard S&P 500 Index Fund (VFINX).
What is an Active Fund?
Active fund managers believe that there are inefficiencies in the market and those can be exploited which results in a higher rate of return than an index or benchmark. Mutual fund managers are actively trying to generate returns higher than the market.
The Case for Passive Funds:
Passive fund proponents always have two main arguments; fees create a drag on performance over time and the average mutual fund does not outperform the perspective index. Both of those statements are true. The lower the fee, the lower the hurdle is for outperformance. If a mutual fund charges 1.00% annually, then they will have to beat the return of the index by more than 1.00% to justify its costs.
The Case for Active:
A proponent of active funds will say that focusing on “average” mutual funds can be misleading. The average person can’t dunk a basketball, but there are people that can. Just because the average mutual fund doesn’t outperform the market doesn’t mean no mutual funds do. Index funds work well went the market is positive, but index funds will follow the market when there are negative returns.
What Does the Research Say?
A study by Jianan Du, Janis Zfingelis and Brandon Thomas of Envestnet titled “Asset Mangement: Investigation of the Asset Class and Manager Selection Decisions” gives us some insights into the behaviors of index funds compared to actively managed funds. The study looked at rolling periods* from January 1980 to May of 2013 of over 9700 different funds and what they found was interesting.
Asset classes can determine whether it makes sense to look at an active manager compared to a passive manager. Typically, in inefficient markets where there is not as much available information, active managers showed a higher success rate. Foreign Mid Cap Growth funds showed a 72% success rate of achieving Alpha (outperformance) for example. However, Large Cap Core showed a 23% success rate of Alpha.
Further, overall market performance matters as well. The research has shown that passive funds will generally outperform active managers in a positive market. Active managers will generally outperform in negative markets.
What Does This All Mean?
As you can see, like most things in life there are positive and negative aspects of both positions. Blending both strategies into your investment portfolio can provide balance in different markets and can allow you to take advantage of inefficient markets. Which side of the debate do you fall under?