The debate over active vs passive investing is as old as investing itself. Will an investor get better results actively picking stocks or is the buy and hold strategy more prudent? Should you invest in actively-managed funds or should you buy index funds? As with all good debates, the best answers to these questions begin with two words: it depends.
Actively-Managed Funds (Usually) Lose to Passively-Managed Funds
The active vs passive investing debate often centers around the history of performance when comparing actively-managed funds with passively-managed funds. Most investors that have read at least a few articles about this debate know that the majority of actively-managed funds do not beat their respective benchmark indices over time. The classic comparison is an S&P 500 Index fund against all other funds in its category.
For example, had you purchased the passive index ETF, iShares Core S&P 500 (NYSEARCA:IVV), five years ago, you would have outperformed 90% of all funds in the large-blend stock category. That’s quite compelling evidence for the passive camp. Performance ranks place the fund ahead of its peers in other time frames as well: 1-year (beats 73% of other funds), 3-year (beats 90%), 10-year ( beats 80%), 15-year (beats 77%).
EMH and the Case for Active Management
Comparing and contrasting performance between actively-managed large-cap stock funds and the S&P 500 only tells part of the active vs passive investing story. You may have heard of something called the efficient markets hypothesis (EMH), which says that asset prices fully reflect all available information. If even a mild form of EMH is true, outperforming the S&P 500 is a challenge because so much information is available about large-cap stocks, making them more “efficient,” and this makes it more difficult to gain an advantage over other investors and beat the market averages.
In different words, most or all of what is known about about a particular company is already “priced in” to the respective stock. So after you add in the expenses of active management — often more than 1.00% of assets — it’s difficult to beat an S&P 500 index fund with an expense ratio of 0.10%.
However, there are inefficiencies in the market where an investor can take advantage.
Here are areas of the market where active management tends to beat passive management:
- Fixed Income: The majority of actively-managed bond funds tend to beat a bond index fund, especially in a rising interest rate environment, when bond prices are generally falling for bonds of longer duration and index fund managers are not able to sell securities to avoid the worst of the downside. The largest bond ETF, iShares Core U.S. Aggregate Bond (NYSEARCA:AGG) loses to the average actively-managed intermediate-term bond fund in almost every time frame you can analyze.
- Sectors: Index funds and ETFs are great tools for gaining access to niche areas of the market but broad sectors, including real estate, health care and technology commonly lose to their actively-managed peers.
- Emerging Markets: Foreign markets are generally less efficient than U.S. markets and this fact makes emerging markets an area where active management can find advantages. A quick case in point is the passive iShares MSCI Emerging Markets (NYSEARCA:EEM), which has lost to category peers 5 out of the past 10 years and loses to 60% of the category for 10-year annualized returns.
One caveat to keep in mind is that all of the above comparisons focus on the past 10 years of performance, which consists almost completely of the largest bull market run in history. The next 10 years could look quite different.
As we’ve all heard, past performance is no guarantee of future results.
The Bottom Line on Active vs Passive Investing
The problem with the active vs passive investing debate is that it often leads to an either/or argument.
For example, conventional wisdom says that if you want to outperform a broad market index, such as the S&P 500, you’ll need to adopt an active strategy of buying and selling the right mix of stocks, or you’ll need to buy the right actively-managed funds, to do it.
However, this is not completely true.
A passive investor that wants to outperform the S&P 500 index could build a portfolio of sector ETFs, such as technology and health, that have historically outperformed the market in the long run, although these passive instruments may not beat their own respective benchmark indices.
Most importantly, the greatest influence on your total portfolio return is not investment selection, as most media sources and financial talking heads may lead you to believe. The greatest influences on performance are timing of investments and asset allocation.
For example, if you can buy more shares of your investments in the midst of a bear market, you’ll average higher returns in the long run. Also, stocks outperform all other major asset types at least 90% of the time for periods of 10 years or more. If you’re willing to allocate most or all of your assets to stocks, and to sectors that have historically outpaced the S&P 500, you can expect to have higher long-term returns.
Finally, there is no such thing as an absolutely passive investment strategy.
The investor decides when to buy shares, which investment to purchase and when to sell the shares. Even if these decisions are made with no consideration of the market environment and with no emotion, they are all active management decisions. There is no active or passive investing — just varying degrees of each — in your overall investment strategy and implementation.
As of this writing, Kent Thune did not personally hold a position in any of the aforementioned securities, although he holds IVV and AGG in some client accounts. Under no circumstances does this information represent a recommendation to buy or sell securities.