The decision between active and passive investing is not an easy one. One can see the arguments on both sides. In order to make an informed decision, it’s important to first understand the distinction between the two. Let’s take a look…
The Difference Between Passive and Active Investing
For those new to investing, the difference between active and passive funds can be unclear. Simply put, a passive fund invests according to a fixed formula or rule, while an active fund allows managers to make independent decisions – as long as they stay within the mandate outlined in the prospectus. For instance, buying an S&P 500 Index ETF, a passive fund example, is a good way to gain exposure to the markets over the short term; however, a market index fund will not outperform its benchmark in the long run. Likewise, a good actively managed fund can outperform its index, but it may require some patience and understanding.
The vast majority of actively managed strategies are in a mutual fund structure, whereas passive strategies are commonplace in both ETFs and mutual funds. The ETFs SPY and VTI are famous examples of passive funds, and notable actively managed mutual funds include Fidelity's Magellan Fund and Vanguard's Wellington Fund.
Fee Differences in Active vs. Passive Funds
The fees of active and passive funds also differ, stemming from each’s underlying strategy. There is no existing rule stating that passive funds must charge lower fees, but due to their rules-based management, operating costs for passive funds are lower, which in turn translates into lesser charges.
The most common disclosure in the investment world, “past performance does not guarantee future results”, is a true and important statement. However, this statement does not leave much for a marketing department to work with and since marketing professionals need to sell something, they turn to fees. A fund’s fee can be used in marketing and advertising. In the past five to ten-years, passively managed investment firms created the perception that all funds are created equal, therefore if one has a lower fee than the other, performance should be better. If all funds are created equal this would be true but all funds are not created equal.
For example, in 2016, the iShares Core S&P Small-Cap ETF (ticker IJR) returned 26.49 percent compared to the Schwab US Small Cap Index (ticker SCHA) which returned 19.89 and the Vanguard Small Cap Index (VB) returned 18.31 percent. These three funds are all small cap blend, passively managed index funds with low expense ratios. The Prospectus Net Expense Ratios for these three funds were 0.07 percent for IJR, 0.06 percent for SCHA and 0.08 percent for VB. As is illustrated, fees may not be the driving influencer of returns.
The rise of low-cost, passive strategies has been great for the industry. In an effort to stay competitive, many actively managed investment strategies have reduced fees in recent years. In addition to lower fees, cheaper share classes, often referred to as “institutional” share classes, have become more easily available for investors working with advisors. Total fees for mutual funds were 2.08% per year back in 1980 according to Professor Kenneth French. More recently, Morningstar found that the average annual fees for actively managed mutual funds had fallen to only 0.77% per year.
Long Term Performance of Passive Investing
Understandably, many investors do not like holding a random collection of stocks selected solely on their market capitalization which may include many poorly run or overvalued companies. Over the last several years passively managed investment strategies performed quite well relative to actively managed strategies. A main contributor to this has been the abnormal market conditions which included four rounds of quantitative easing and a zero or negative interest rate policy instituted by central banks. One of the main goals of these programs was for the stock market to move higher, which worked, but it resulted in stock prices rising regardless of valuation or quality. We need to remember that Warren Buffett said, “that only when the tide goes out do you discover who's been swimming naked.” The Fed has already shifted into rate hiking mode, so the higher relative returns of passive funds in recent years may be receding with the tide.
In point of fact, absolute returns are not the best way to evaluate mutual fund performance. The superior risk-adjusted returns of many active funds might seem abstract and theoretical today, but those risks will become all too real if we see a return to the bear markets of the early 21st century. Many of the "underperforming" actively managed funds of the 1990s bull market actually did fairly well during the S&P 500 bear market of 2000-2002, and we could see a repeat of that scenario at some point.
Unfortunately, investors seldom give good fund managers the time that they need. People want to get in on funds that have outperformed the market over the last several years, but this sort of performance chasing often leads to poor returns. Many investors don't understand that an actively managed fund with higher returns in the long run can dramatically underperform in the short run. That is why it is essential to hold actively managed funds over a full market cycle of five to seven years.
Active Investing for the Long Run
It should be clear by now that the decision between active or passive management involves quantitative factors and qualitative analysis. Simply chasing returns just doesn't work. A more active long term approach is needed.
Long term active investing often seems complex or even overwhelming, but we can help you invest in active funds that fit you and your individual situation.. Taking the time to come up with a sensible plan and giving it time to work is one of the best long term investments that you can make.
The ACG Difference
At ACG, our teams’ ongoing quest to stay abreast with what’s happening in the world means we keep a close eye on market intelligence, global influences and geo-political factors. We can help you come up with an investment plan that is right for your situation.