The massive growth in popularity of passive investment over the past four years has intensified the active and passive investment debate, which, in essence, is a strategic decision that all investors must make down a duelling divide: 1) to actively try and beat the market, 2) passively allow investments to grow with it, or 3) develop a method to allocate a mixture of both strategies.
In August 2018, the portion of US domestic equity funds that were passively managed exceeded those that were actively managed for the first time, according to Bloomberg Intelligence. Then, by the end of 2020, passive funds had already taken 54% of the US domestic equity funds market.
What was responsible for this rapid shift in investment strategy de jour?
Well, a big part of it was due to the inability of active funds to outperform their market indices despite charging high fees. For example, in 2020 more than 57% of all active domestic (US) funds underperformed their indices, according to the S&P Indices Versus Active Scorecard (SPIVA). Even between June, 2020 and June, 2021 when the market was generally down, 53% of active funds still underperformed, according to the Morning Star Active/Passive Barometer.
Nevertheless, many investors continue to embrace the active management strategy (which is why there is still a debate) based on the desire for higher-than-average returns and the belief that active funds will do better in bear markets, among others.
On the other hand, the failure of active funds and the lower cost and greater transparency of passive funds have led many more investors to embrace the passive investment strategy, as well as many experts to continually recommend it.
So, which strategy should you embrace between active and passive investment? We’ll answer that question in this article by considering the pros and cons of both strategies and the key factors you should consider before choosing one or the other.
We’ll look at:
At the end of the article, you’ll have all the information you need to make a smart investment decision.
[Do you want to start applying a passive or active investment strategy (or a combination of both) to invest in stocks, ETFs and other assets? Sarwa can help you choose the right strategy through our investment platform and stock trading app. Schedule a free call with a Sarwa wealth advisor to get started.]
Before getting into the thick of things, it’s good to start with a brief introduction of both active and passive investment.
Said simply, active investing or management is an investment strategy where investors attempt to earn higher returns than the market.
Market return is measured by the performance of a market index, which is a collection of certain stocks or bonds that meet certain criteria. For example, one of the most common indices is the S&P 500 Index, which tracks the performance of the largest (by market cap) 500 US companies. Therefore, active investors attempt to use their investment acumen to earn higher returns than one or more indices.
There are two types of active investors: individual and institutional.
The individual active investor will pick his or her own securities (stocks/bonds/REITs) in an attempt to outperform the market. Institutional active investors are groups such as hedge funds, mutual funds, and actively managed exchange-traded funds (ETFs).
These institutional investors combine money from different retail investors into a single fund with the aim of earning a higher return than the market (as measured through a particular index).
On the other hand, passive investing is a strategy where investors attempt to match the performance of the market. They do this by attempting to mirror the holdings of a particular market index.
For example, the Vanguard S&P 500 ETF (VOO), a passive fund offered by Vanguard Inc., mirrors the holdings of the S&P 500 Index and attempts to match its returns.
In the chart below, see how the performance of VOO (in blue) is almost indistinguishable from that of the S&P 500 Index (in yellow) when comparing the growth of a hypothetical $10,000 over 10 years.
Source: Vanguard Inc
By now, you are probably giving hats off to active investing: “Isn’t it better to outperform the market than to match it? (Obviously, is more money not better than less?)”
Well, it’s never that simple.
Now let’s unpack things a bit.
Comparing active vs. passive investing
In an attempt to achieve its aim – that is, outperform the market – active management strategy often involves the frequent (to varying degrees) purchase and sale of securities (also known as high turnover).
Active investors are constantly researching the market (through fundamental and/or technical analysis), trying to offload underperforming shares and onload those with greater potential for higher returns. This is why mutual funds, hedge funds, and actively managed ETFs employ various investment analysts to research the market and portfolio managers to make those buy/sell decisions.
What arguments have been made for active management over passive investing? Let’s consider some:
Unlike a passive investment strategy where you mirror an index and then take your hands off, active management gives you the flexibility to buy (potentially) high performing stocks and sell underperforming ones.
The argument by advocates of active management is that such flexibility is beneficial in volatile or bear markets.
“A key benefit of active management is the ability to protect against downside in falling markets,” according to Waverton Inc., an investment management company in London. The idea here is that active managers can quickly buy and sell in volatile markets or turn failing stocks in bear markets into cash or bonds to prevent more loss.
However, as said in the introduction, 53% of active mutual funds analysed by Morning Star, a major financial services firm, still underperformed the market between June 2020 and June 2021, a very volatile period. Also, during the first six months of 2020 (which was a bear market) “active funds’ performance was neither categorically better nor worse than that of their index peers during this period,” said Ben Johnson, a writer for Morning Star.
Recently, Peter Lynch, an investment guru who outperformed the S&P 500 Index when he managed Fidelity Megallen Fund between 1977 and 1990, criticised the wholesale move into passive investing as a mistake in an interview with Bloomberg Radio.
For him, active managers have beaten the market in the past and will continue to do so; therefore, to move into passive investing is to “miss the boat.”
However, the 2020 SPIVA report still showed that more than 67% of active US equity funds underperformed the S&P Composite 1500 index (which tracks the performance of 90% of all US publicly traded companies) in 2020, 72.8% underperformed over three years, 83.2% over 10 years, and 86% over 20 years.
Percentage of US equity funds underperforming their benchmarks
Source: SPIVA US Scorecard 2020
One of the factors responsible for this underperformance is rising competition among mutual funds, hedge funds and actively managed ETFs.
What was once “trade secrets” is now common knowledge and it’s becoming more difficult (though not impossible) for fund managers to gain an advantage over the market.
“In the past, executing that strategy — buying high quality stocks that are cheap — used to require a lot of work. But today, you can replicate a lot of this with an ETF at a very low price,” said Larry Swedroe, chief research officer at Buckingham Wealth Partners, a wealth management firm.
A third argument supporting active managers is that they can better mitigate risk through various hedging tools like short sales and put options. Said simply, hedging is a way of minimising risk of loss by balancing one transaction with another and it’s a favourite strategy of hedge funds.
Nevertheless, despite the fact that hedging is not new to active fund managers, a big percentage are still underperforming the market, as shown above.
A final argument we’ll consider is tax loss harvesting. This is a situation where active fund managers sell underperforming stocks at a loss in order to reduce the tax they will pay on other stocks they have sold at a profit.
Though tax loss harvesting can be beneficial, active fund managers must be careful of the wash sale rule, which prevents them from receiving tax benefits for a stock that they quickly repurchased (or similar ones) after selling.
While tax loss harvesting can be beneficial (research by MIT and Chapman University showed it increased annual returns by 1% between 1928 and 2018, according to Forbes), it can also be a distraction from the primary investment strategy.
However, in a bid to deliver these advantages (which they often don’t do), active investors have to deal with the numerous disadvantages inherent in the active management strategy.
Some of these disadvantages include:
For individual active investors, buying and selling frequently can lead to high brokerage costs that eat into whatever profit is made. However, this disadvantage is less serious in this day and age when many trading platforms like Sarwa Trade charge zero trading commission.
At the institutional level, mutual funds, hedge funds, and actively managed ETFs have higher expense ratios compared to index funds and passive ETFs.
As seen above, active managers have been underperforming the market for many years now. While the prospect of higher returns when you make the right choices is scintillating, there is also the risk that you will make the wrong decisions and lose money.
Frequent sales of securities will result in more tax incidents and higher tax liability within the fund (expenses that will be passed on to investors). Though tax loss harvesting can reduce the overall tax liability, the tax differences can still be significant.
In a passive investment strategy, investors seek to match the performance of an underlying index by mirroring its holdings. Unlike active funds, there is no constant buying and selling in a bid to outperform the market.
Since most indices have hundreds and thousands of holdings, it’s difficult for an individual to create a passive strategy by buying stocks on his or her own. How much money would you need to buy 500 of the largest US stocks to match the S&P 500 Index? A lot.
Consequently, the two major instruments of passive investing are index funds and passive exchange-traded funds (ETFs), which can be purchased by an individual or institution.
While the former are only traded at the end of the day, the latter has the advantage of being traded during trading hours – which means more liquidity.
Differences between ETFs, mutual funds, and index funds
[For more on ETFs and how they differ from index funds, read, “What Is An ETF? Everything You Need To Know (2021)”]
Can there be any advantage to tracking the market’s performance rather than trying to beat it? Well, let’s see.
Both index funds and ETFs have lower expense ratios compared to their active fund counterparts.
Commenting on the high cost of active managers, Warren Buffett said, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.”
What then was his solution? “Both large and small investors should stick with low-cost index funds.”
When you invest in an ETF or index fund that contains hundreds or thousands of stocks or bonds, you gain diversification benefits, which reduces your risk. Every ETF or index fund is diversified by industry (finance, healthcare, consumer discretionary, etc.) and/or market cap (large, mid, low) and/or market (US, emerging, developed) .
[For more on diversification and how it minimises risk, read, “Learning The Importance of Portfolio Diversification Can Prevent Huge Loss. Here’s Why.”]
Passive funds are more transparent about the securities they hold, unlike active managers who sometimes treat their holdings as trade secrets that can’t be shared.
In fact, ETFs are required by law to regularly disclose their holdings to shareholders.
Since there is no frequent buying and selling within the index fund or ETF, there are less tax incidents. Taxes are payable only when investors sell their index funds or ETFs.
Nevertheless, there are certain arguments against passive management:
Passive funds don’t have the flexibility of the active management strategy. For some investors, this is especially concerning in bear markets since even if a particular stock or bond is nosediving, it still remains in the portfolio as long as it remains in the underlying index.
You can understand how frustrating this can be for those who don’t have the patience to ride the bear market.
Seeking to track the performance of the market instead of beating it can seem too timid for the more ambitious and risk-seeking type of investor. As you may have thought in the beginning, “why not try and beat the market instead of mimicking it?”
There is much more fun when you are buying and selling stocks regularly, whether as an individual or institution. The thrill of researching, making profitable decisions, manoeuvring the market is absent in passive investing. This is precisely why we are currently seeing a revolution in retail investing – there are many trading apps out there that have gamified stock trading.
That being said, if you are looking for the thrill, investing is not the strategy. Instead, try a casino.
Arguments for and against active and passive investing
We have now come to the elephant in the room in our discussion of active vs. passive investment: which strategy should you embrace?
First, understand that you can actually combine passive and active investing in such a way that choosing between them does not need to be as critical as it once was. We’ll consider this in a bit.
Nevertheless, many investors prefer to be on one side or the other and it depends on us to explore this question.
So, should you follow Warren Buffett who recommends low-cost index funds, and once placed a bet on a passive fund outperforming an hedge fund, or Peter Lynch who calls the wholesale move to passive investing a mistake?
The best way to answer this question is to reflect on certain personal factors that you should consider when making an investment choice.
First, if you are not an investment expert, you should not try using active management as an individual. Even if you have the acumen, you might not have the time to do the research that some get paid to do. “Don’t try to time [the market] yourself because you’ll probably lose,” said Ray Dalio, chairman of Bridgewater Associates, an investment management firm.
If you are in this situation, you only have two good options: invest with active institutional funds or a passive fund (index funds or passive ETFs).
[For more on the difficulty and downsides of timing the market, read, “Does Market Timing Work?”]
Mutual funds (active) and some index funds (passive) typically have a minimum investment requirement. You can’t invest with them if you are unable to meet that requirement.
On the other hand, you can purchase a fraction of a passive or active ETF with the little amount you have. Also, digital financial advisors like Sarwa that create a portfolio of passive funds for investors have very low minimum investment requirements (it is $5 for Sarwa).
Consequently, if you don’t have the thousands of dollars that many mutual funds and some index funds will require, ETFs (passive or active) are your best option.
However, if you have the time and investment acumen, you can also be an active individual investor with whatever amount you have. Sarwa Trade allows you to buy a fraction of a share.
Only actively-managed ETFs can provide the same level of diversification that passive investing offers. Since they track the same index as their passive counterparts, actively managed funds tend to have the same level of diversification.
Therefore, if you desire to minimise your risk through diversification, you should use passive investing or an actively managed ETF (other factors, below and above, held constant).
Note that actively managed ETFs tend to have advantages that other active funds don’t have (broad diversification and fractional investing). Broad retail investor interest in these funds has been rising with ARK Innovation ETF (ARKK), created by Cathie Wood, CEO of ARK Invest, which is leading the charge with more than $12 billion asset under management (AUM). Nevertheless, they are still exposed to the same disadvantages as other active funds: higher costs, higher risk, higher tax.
The cost of the higher risk associated with actively managed ETFs became very evident in 2021. Cathie Wood’s flagship ETF, ARKK, was a flop, dropping down 21% in 2021, while the S&P 500 was up about 30%.
If you are a long-term investor, passive investing is a better option. While it is bad enough that most active funds underperform the market, it is even worse that the number of those who fail increases as the time horizon increases. That is, more active funds have underperformed the S&P 500 over the past 20 years (86%) than over the last three years (79.2%) as we saw in the SPIVA report.
Moreover, most successful investors have advocated for long-term investing since the potential for higher returns and lower risk rises with the time you spend in the market. “Always invest for the long term,” advises Warren Buffett.
Nonetheless, if you are investing for short-term income, you may consider active investing (with a mutual fund or actively managed ETF if you don’t have the investment acumen) instead of passive investing. This is because those who invest for the short term can’t wait to ride bear markets, they need to always sell off underperforming securities and buy high performing ones to make short-term profit.
[If you are interested in learning how to develop the investment acumen to trade stocks as an active individual investor, read “How To Make Money Trading Stocks: The Ultimate Guide”]
Similarly, many financial advisors prefer to use active investment for retired people (namely through mutual funds) who aim to generate a particular amount of income from their nest egg.
These advisors choose very specific stocks that can deliver that required income (through dividends). Since they know the specific stocks that can provide the dividends they need (and companies don’t change their dividend payout ratio frequently), there is no need to track an index. Also, when a company wants to change their dividend policy to the detriment of investors, they can quickly sell that stock and purchase another.
Also, if you are one of those who derive some sort of thrill and excitement from the stock market, active investment will suit you more than passive investment. However, remember the wise words of Paul Samuelson, a Nobel Prize-winner in Economics: “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” Investing for concrete goals should be prioritised over investing for entertainment.
The high cost of active investing is another reason why passive investing is better for long-term investors. The difference between the expense ratios of an active fund and a passive fund can become significant over the years.
Of course, the higher cost might be justifiable if active investing can provide consistent higher returns. However, that’s a tall order that most active individuals and institutions have not met over the years.
By combining these five factors above, you should be able to identify which investment strategy is based on your financial situation.
As said above, there are now attempts to reduce the antipathy between active and passive blending by blending them in an investment portfolio.
For example, Live Mint, a financial news agency, suggests a passive investing approach for large-cap stocks and an active investing strategy for mid-cap and low-cap stocks. They also suggest using passive investing to access unfamiliar markets (international non-US markets) and active investing for niche segments.
Likewise, State Street Global Advisors, one of the top players in the ETF market, suggests ten strategies for combining active and passive investing.
Let’s make it clear: choosing one of these strategies does not mean you can’t benefit from the other.
At Sarwa, we, like Buffett and others, encourage you to invest for the long term. To this end, we help you create a portfolio of ETFs (passive funds). We seek to understand your financial situation, time horizon, and risk tolerance and then provide you with a portfolio that will help you achieve your investment goals.
And if you are an active investor, we provide a trading platform – Sarwa Trade – where you can buy and sell securities with zero commission, no minimum investment requirement, and bank-level SSL security.
In this way, Sarwa allows you to apply both active and passive investment strategies at the same time, or pick the strategy that best suits your personal risk appetite.
Are you still unsure which one to choose between active and passive investment? Schedule a free call with a Sarwa wealth advisor and we’ll help you make that decision.
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