For the past few years, a big debate in the investment world has been active investing vs. passive investing and which style is better.
Active investing involves picking stocks with the hopes of outperforming the market or achieving a higher rate of return with lower risk than a particular benchmark. Most commonly, active investing is practiced in the form of purchasing an actively managed mutual fund. Active investing is also commonly associated with higher fees than passive investing.
Passive investing, on the other hand, most frequently involves purchasing an index mutual fund or an ETF that seeks to mirror an index. Instead of trying to beat the market, the passive investment seeks to earn market returns minus fees, and the fees are generally lower than that of actively managed funds.
But everyone is focused on the wrong things here.
The conversation shouldn’t be about active vs. passive, as if one style of investing is the best for every asset class in every market for every investor. It’s silly to think any style of investment would be good for everyone in every situation.
The conversation should be about where an active manager can add value, and where they cannot.
Over a 15-year period, 92.33% of large-cap managers, 94.81% of mid-cap managers, and 95.73% of small-cap managers failed to outperform on a relative basis1. The argument can be made that this is because most markets are efficient and there is so much talent competing in these spaces that most of the alpha is squeezed out.
But active investments can have a place in your portfolio.
The Wharton Wealth Management Initiative says active managers can add value in the follow ways:
- “Flexibility – because active managers, unlike passive ones, are not required to hold specific stocks or bonds
- Hedging – the ability to use short sales, put options, and other strategies to insure against losses
- Risk management – the ability to get out of specific holdings or market sectors when risks get too large
- Tax management – including strategies tailored to the individual investor, like selling money-losing investments to offset taxes on winners.” 2
Active management can also help psychologically in times of uncertainty. When the market is declining, it feels good to know a person is watching your investments and making active decisions. Knowing a portion of your money is being carefully analyzed by a trained professional is comforting.
Without this type of attention, most people feel like they have to do something themselves to alleviate the pain they are feeling from market declines. This often leads investors to sell depreciated assets resulting in a permanent loss of capital.
In a nutshell here: the effects on your behavior that an active manager can have is very powerful for long term results. At the end of the day, the only thing that matters is making sure you get from A to B and accomplish your financial goals. So it’s not about active vs. passive. Be more open minded than that. It’s about using both active and passive strategies to help you accomplish your financial goals.
1Soe, A. M., CFA, & Poirier, R., FRM. (2017). SPIVA® U.S. Scorecard. RESEARCH SPIVA, 1-33. Retrieved July 17, 2018.
2Active vs. Passive Investing: Which Approach Offers Better Returns? (n.d.). Retrieved July 17, 2018, from https://executiveeducation.wharton.upenn.edu/thought-leadership/wharton-wealth-management-initiative/wmi-thought-leadership/active-vs-passive-investing-which-approach-offers-better-returns