For years, one of the most contentious debates in the investment world has been the merits of active vs. passive strategies. But to ask which approach is better assumes that it’s an either/or situation, when in fact it’s much more nuanced than that.At one time, active investing, which is nothing more than intentionally buying and selling stocks, was the only kind of investing. Investors either did their own research to create an investment portfolio or they paid a financial advisor to do it for them. That all changed with the creation of the first mutual funds in 1924, which became very popular because they were managed by professionals who actively traded within a specific strategy in reaction to or anticipation of changing market conditions. Then along came John Bogle, recently deceased at the age of 89, who created Vanguard’s first low-cost index fund.
Almost Everyone Wins in a Bull Market
During the current bull market, which started on March 9, 2009 and became the longest ever on August 22, 2018, investors could sleep easy by simply putting their money into low-cost exchange traded funds (ETFs) that mirrored the performance of a major index. On March 9, 2009, the Dow Jones Industrial Average, one of the market’s leading benchmarks, was at 6,547 points and hit an all-time high of over 26,828 on October 3, 2018. The Nasdaq and the S&P 500 also hit their highest points last year, in August and September, respectively, and most investors were pretty happy.
But nothing lasts forever. When volatility returns in a big way the indexes start to lose momentum, those gains can quickly disappear, as passive investors painfully discovered when December’s volatility erased the gains they had made in the previous 11 months.
The Difference between Active & Passive Investing
For the most part, investors taking the passive approach are looking at the long-term by using a buy-and-hold approach. Investing in a fund that tracks the Dow or the S&P 500 means that you own a piece of every fund listed in that index. Those holdings only change when a new company is added or subtracted from the index. These investors know that the market is going to have ups and downs, but believe that over time, the highs will more than compensate for the lows. Passive investors don’t expect to beat the market, but rather to get the same returns as the market, minus fees.
Active investing is just that. It’s a hands-on approach that entails regular trading with the goal of outperforming the market’s average returns.
So, in a nutshell, the difference between active and passive investing is that passive investors are willing to settle for whatever the market gives them, where active investors are looking for big wins. But bigger wins also mean taking bigger risks.
Pros & Cons of Passive Investing
The most obvious advantage of passive investment vehicles is that they have a very low cost because there isn’t a lot of trading involved. A passive fund will only contain whatever stocks make up its benchmark index.
Because the fund can only contain the stock of companies included in the index, investors always know exactly what it is they own. There are also tax advantages to this approach since passive investors are rarely hit with huge capital gains in any given year.
The flip side of those advantages is that passive funds can only include stocks that are part of their index and in the same proportion. The managers of those funds cannot make strategic decisions when market conditions change. So, when Apple and other tech stocks that make up a significant portion of many indexes started to fall precipitously in early January, there was nothing passive managers could do but watch the value slip away.
There can also be a lack of diversification in passive investing. A fund tied to the S&P 500 holds stock only in the largest companies in America. By mandate it totally ignores mid-cap and small-cap companies which, in many cycles, outperform the large caps because they still have growth potential. Growth for most of the companies in the S&P 500 is going to be incremental at best.
The biggest negative, though, is that passive investors will never beat the market and will miss out on the massive upside that active managers get when they make the right call.
Pros & Cons of Active Investing
Since active managers are not bound to any particular index, they can buy whatever stocks make the most sense at the time, within the parameters outlined in their prospectuses.
Active managers can protect against potential losses by shorting stocks they expect to decline or using options. And when they see too much risk, these managers can divest troublesome holdings, while a passive manager has to own whatever’s in the index.
Taxes play a bigger role in active strategies, since outsized returns can trigger big capital gains taxes, but most managers usually also have losing stocks they can sell to lessen the tax burden.
But good managers don’t work cheaply and expenses can be considerably higher, often one percent (one hundred basis points in financial lingo). That may not sound like much to the uninitiated, but when compounding is taken into consideration over an investment timeline of 30 years or more, that can be a significant amount.
The freedom that active managers have to pick and choose where they invest means they are also free to take on a lot more risk. Often investors choose a money manager or mutual fund based on its performance the previous year, but it’s typically hard for managers to strike gold consecutively. One of the penalties of success is that money pours into the “hot” managers and funds and they are sometimes unable to then deploy that capital in ways that will bring similar returns.
Passive or Active Investing: What’s the Right Answer?
When it comes to investing there’s never a straight right or wrong answer. Each investor’s situation will be different based on things like income level, investment time horizon, risk tolerance, personal values and long-term goals. So the question posed at the start of this article is not the right one. Active and passive investment strategies are not mutually exclusive. In the real world, there are appropriate uses for both active and passive strategies and a truly diversified investment portfolio should probably contain both.