Active vs. passive investing: which is better?
In my previous blog posts, I classified myself as a passive investor because somewhere around 95 to 98% of my portfolio is in index funds. For more details about my asset allocation, see my 2020 in review article.
But what exactly is passive investing beyond just buying Vanguard index funds? What are the fundamental differences between passive investing and active investing? Which method is better? If you talk to any passive investor, myself included, you’ll probably be lead to believe that passive investing is the greatest thing since sliced bread, but the truth is more nuanced. Let’s open this can of worms.
To start with, trading stock is only meaningful if the stock’s price does not reflect a company’s actual value. If a company’s stock is intrinsically worth $50 per share, and trades at $50 per share, there are no meaningful trades to make. You might as well hold the stock for eternity and take your dividend payments. If, however, someone was willing to sell a share at $40, you would jump on the opportunity to buy it. But why would they sell it at $40, and how do you know that it’s actually worth $50? And what if the company is worth $40 today, but you know with certainty that it will be worth $50 tomorrow? Wouldn’t you go ahead and buy the stock today anyway?
In fact, how to properly determine a company’s intrinsic value today and in the future is the great question of investing. For example, one traditional method of valuation is to look at the company’s performance metrics in the form of multiples, such as price-to-earnings (PE) ratio. In other words, what is the price of the company’s stock relative to the company’s profits and does it make sense compared to its peers and the broader market? But this method of valuation breaks down for companies that are not yet profitable. How do you properly value a company that is currently losing money, but is building the infrastructure for potential future profit? How do you account for growth?
As it turns out, there are many different methods of valuation, each with its own merits. Regardless, the fundamental belief of active investors is that it is possible to determine a company’s valuation through various methods, and that price distortions do exist in the market place. At any given point in time, some companies are undervalued and some companies are overvalued. Through techniques such as fundamental analysis, technical analysis, or factor analysis, active investors hope to figure out a company’s intrinsic valuation, identify undervalued companies, and get a better “deal” on those stocks, which translates into better investment returns. Conversely, they can sell overvalued stocks if they believe the buyer is paying more than what the stock is worth. In practice, some active investors pick individual stocks; many invest in actively-managed mutual funds (where they pay a portfolio manager to make the picks for them); and some, like Warren Buffet, have the capital to buy entire companies that he believes are undervalued. Active investing is not synonymous with trading, as many active investors hold on to their investments for a long time to reap the benefits of growth and dividends, and are not, in fact, looking to “flip” their investments quickly.
Passive investors, on the other hand, mostly fall into one of two camps: those who believe in the Efficient Market Hypothesis (EMH), or those who don’t have the time, patience, or skills to do the necessary research for active investing. The Efficient Market Hypothesis was popularized by Eugene Fama, a professor of economics at the University of Chicago, in the 1970s. It basically asserts that the markets are efficient and that stock prices already reflect all available information about a company. Therefore, a company’s stock price at any point in time is the intrinsic value of a company. As new information about a company comes to light, its stock price will naturally adjust to once again reflect the company’s new intrinsic value. In other words, there are no consistent price distortions or mismatches to take advantage of, and attempts to systematically identify price distortions are unfruitful in the long run. Therefore, passive investors flock to index investing whereby they simply aim to to capture the returns of the overall market itself and do not bother with trying to cherry pick “good” from “bad” stocks.
The history of investing was entirely dominated by active investing until the introduction of index funds opened passive investing to the masses. Market indices had already existed for some time and it became increasingly obvious that many active mutual funds were falling short of the market index. People wondered why they couldn’t just buy the index itself. In 1975, Vanguard founder John Bogle created the world’s first index fund. Once thought to be little more than an academic exercise, passive index funds are now the dominant type of mutual fund in the United States by assets under management.
Empirically, most actively managed funds and most active investors do not beat the market itself in the long run. For example, the SPIVA 2019 U.S. End-Year Report shows that in 2019, only about 30% of all domestic funds outperformed the S&P 1500 composite index itself, and over a 10 or 15 year period, this drops to about 10%. To add insult to injury, actively managed funds have much higher expense ratios than index funds. Therefore, not only are most active funds failing to outperform the market, but they are charging higher fees for the privilege of active management. While in any particular year, skilled or lucky active management can beat the market, over time the results trend back to the market’s average returns. And if a particular method of active management could consistently guarantee market outperformance year after year, eventually all investments will flock to that method, resulting in that method having the same returns as the overall market again.
In fact, active management is a zero-sum game compared to the overall market itself. For an active investor to outperform the market, another active investor must necessarily underperform the market. See Nobel prize winning economist William Sharpe’s short essay on this point. When an active investors make gains in excess of the market itself, those returns are coming from another active investors’ losses. After the fees of active management are accounted for, active management is overall a negative-sum game.
With that being said, there is plenty of evidence that the markets are not perfectly efficient. Firstly, the markets are not fully transparent and all information about a company is not always available to all investors simultaneously. Secondly, human behavior isn’t rational and many people make decisions based on fear, greed, or other emotions, rather than information. One only needs to look at the many examples of market bubbles and crashes throughout history to see that market prices can stray far from reality. The recent stock movement of GameStop (GME) is an excellent example of market inefficiency compounded by human behavior. Therefore, price distortions will always exist in the marketplace, and as long as price distortions exist, active investing can take advantage of them. It is trivial to find countless companies (such as Apple and Amazon) as well as investors (such as Warren Buffet) who have outperformed the overall market. The active investor, then, is someone who is willing to undertake the task of beating the average. This is either brave or foolish, or perhaps both.
When it comes to professional money management, here’s how actively managed funds compare to index funds:
Passive investing
Returns: Passive investors will capture the performance of the market or market index itself, minus fees. The passive investor will never beat the market or index, except in rare cases of tracking error in favor of the investor.
Timing: Passive investors do not try to time the market.
Risk: Passive investors take on the same risk as the overall market or market index.
Diversification: Passive portfolios are as diversified as the overall market or market index, but this can be deceptive; see caveats below.
Fees: Passive portfolios have lower fees. Some passive index funds have no fees at all.
Tax efficiency: Passive funds have lower turnover and fewer taxable events.
Difficulty/effort: Passive investing requires very little knowledge, skill, or research.
Caveats: Passive index funds do not discriminate in investing. Therefore, passive indexing will, by definition, invest in poorly managed or failing companies, as long as that company is still included in an index or total market. Additionally, passive index funds may not be consistent with your personal investing philosophy and will invest in companies with poor social, ethical, or environmental practices. In a market cap-weighted index, the only criteria used to determine how much money you invest in a company is the size of the company’s market capitalization. For this reason, almost all index funds are “top-heavy” and majority of the fund’s value is held in a minority of underlying companies.
Active investing
Returns: The sky is the limit with active investing, but the average active investor will underperform the market or market index after fees. Active investing is the only way to beat the market, however.
Timing: Active investors can try to time the market for optimal opportunities to buy or sell.
Risk: Active investors can modify how much risk they take by their choices. However, their choices may not be the correct ones.
Diversification: Active portfolios are less diversified. Since active investors avoid what they believe are bad investments, active portfolios have less holdings by definition.
Fees: Active portfolios tend to incur higher fees from transaction costs, and actively managed mutual funds have higher expense ratios.
Tax efficiency: Active investing has higher turnover (buying and selling stocks), which creates taxable events.
Difficulty/effort: Active investing requires more knowledge, skill, and research.
Caveats: Actively managed funds can in fact be “closet indexers”, where the majority of their holdings mirror an index. Fund managers do this to avoid performance that deviates too far from the market, yet still charge high management fees.
Active managed funds can suffer from survivorship bias. A company can create dozens or hundreds of active funds, and shut down funds which underperform the market. Over time, it can still be left with several funds that appear to consistently outperform the market. It is not always possible to tell if outperformance came from skill or luck.
The truth is, very few investors are purely passive or purely active. Real investing falls along a spectrum. Even a 100% passive index fund investor must still make decisions such as asset allocation between stocks versus bonds, and US versus international index funds. These decisions are still driven in part by the investor’s belief in valuation, except instead of assigning value to individual stocks, the investor is valuing entire markets, asset classes, or countries.
From a philosophical standpoint, I identify with active investing, because the idea of finding price mismatches, picking the right stocks, and pruning the poor performers is both enticing and sensical. Also, the idea of rewarding good businesses with investment capital and punishing bad businesses by not investing is an appealing characteristic of a meritocratic free market. I also don’t believe that the markets are perfectly efficient, at least in the short-term, although the markets do tend to correct outliers in valuations in the long-term. From a practical standpoint, however, I am mostly a passive investor, because I don’t believe that I can get better performance from active investing. It is a shame that active investing is a negative-sum game, because at least on an individual level, time, skill, and effort are not consistently rewarded. But passive investing provides an avenue for ordinary people like me to participate in the stock market, and for that I am grateful.
Regardless of which camp you fall into, remember that patience, proper asset allocation, and risk management are key. Always do your research and due diligence, and never invest with emotion. I hope your investments are profitable and help you to meet your financial goals.
Happy investing!
