5.3 Passive vs. active investing

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I feel compelled to mention the prolonged debate in the media about “passive” versus “active” investing.  The so-called passive style of index investing appears to be conquering the investing world as shown in this chart.

Because the fees for index funds are so much less than for actively managed funds, the passive investing trend has important ramifications for investment industry profits.  And when profits and compensation levels are at stake, the debate can become quite vociferous.

There are many professionals in the finance world with technical knowledge, education, and experience far in excess of mine who contend that they can produce significant excess returns or alpha.  I in no way want to enter this highly technical debate armed only with my layman’s knowledge obtained from my personal investing journey.  I will stipulate that a select few technically knowledgeable people probably exist who can produce significant excess returns, at least under select conditions.  But for the vast majority of individual investors this superior technical knowledge is out of reach, unless they can devote their lives to becoming a full-time finance expert.  And given that it costs money to have someone else “actively” manage your investments, there should be a mindful path through the active vs. passive quagmire that allows an investor to achieve returns that are nearly as good as more expensive approaches.

Much of the passive vs. active debate involves a fair amount of smoke and mirrors.  Arguments both for and against often appear somewhat tangential and include more than a few red herrings as well.  For example, there is much debate on how to most accurately make comparisons to indices, and whether such benchmarks are set before or after performance is evaluated.  Perhaps the results from Article 5.2 showing virtually no evidence that anyone can produce excess returns are somewhat pessimistic or optimistic.  Regardless, it seems unlikely that resolving minutiae like the exact methods for comparing to benchmarks will dramatically increase available estimates of active investing performance.

Similarly, some have pointed out that “passive” investing is not really passive at all.  The individual investor still has to actively select the appropriate index funds for their purpose, and the fund managers must make myriad decisions each day to try to best mimic the indices they track.  But that simply avoids the question of whether we, the individual investor, are better off selecting index funds or something else.  So, rather than devolve into detailed definitions of active versus passive and what’s the exact difference between the two, we should define the issue more broadly as “simple” versus “complex” investing.  That way we can get past most of these detailed debates.

So, why should the individual investor favor the simple investing approach?  For one reason, as the data in Article 5.2 make clear, finding and selecting the few superior active fund managers who are operating funds that fit within our investing plans is probably more difficult than making relatively simple investments choices using readily available index funds.  And selecting a great fund manager may be equally as hard as the complex exercise of picking individual stocks and bonds.  (The relative difficulty of selecting individual stocks as compared to funds is discussed more in Article 7.1).

Another reason to favor simple investing is that seeking excess returns through “complex” investments is likely not necessary for you to meet your long-term investing goals.  Cullen Roche recently said it better than I could:

  • The primary reason why the intelligent asset allocator should avoid the pursuit of excess return is that this is not an essential financial goal for most savers.  While generating high risk adjusted returns would be a nice benefit of intelligent asset allocation it is not necessary as part of a smart financial plan.  Additionally, the intelligent asset allocator understands the arithmetic of the global financial markets and how difficult it is to consistently beat the market as evidenced by the annual SPIVA Scorecards…The customer cares more about generating a sufficient absolute return as opposed to a sufficient relative return.

Yet another reason is that complex investing has to overcome several additional hurdles in order to achieve this excess return, sometimes called “friction”.  These frictions include management costs and higher taxes; actively managed funds often have higher taxes than index funds held over the same period.  Again Cullen Roche notes:

  • Because the pursuit of alpha is often expensive (see hedge fund fees and after tax returns or the high cost of chasing returns), the intelligent asset allocator will generate a higher return by reducing these frictions as much as he or she can.  As shown in Bogle (2003), Barber (2000) & Vanguard (2014), taxes and fees are the most important controllable frictions in portfolios.  Therefore, the intelligent asset allocator should simply try to ‘take the market return’ as efficiently as possible…in a manner that is in-line with their risk profile.

I talked a little about costs in Article 3.  It’s worth illustrating in more detail how costs and taxes impact investment returns.  Vanguard presented this graph of the relationship between fund costs and returns.

Cost correlation

This correlation between costs and returns makes a big difference to your investment growth overtime as shown in this graphic of the hypothetical growth of $100,000 with 1, 2, and 3% management costs.

Effect of costs on growth

Over 30 years with a 6.5% annual return, a one percent difference in fund expenses will end up costing you about $100,000, which is equal to 100% of the original investment in this case.  And here is one more Vanguard graph depicting the return differences for a wide variety of high and low-cost funds.

Vanguard Cost Fund Graph

Similarly, the tax burden of simple index funds is often much lower than more complex actively managed funds as shown in this Vanguard graph.

Vanguard Taxes Funds

In the above graph the median index fund had a tax burden of 0.71% vs. 0.98% for the median “actively” managed fund.  This nearly 0.3% difference will be added on top of any differences in annual return caused by management costs, which as noted above, can be in the 1 to 2 percent range.  Again, this slim sounding margin in annual returns can make a huge difference in the growth of your investments in 20 or 30 years.

Winning the Losers Game” by Charles Ellis  reaches the same conclusions as we’ve found here.  Excess return is far harder to achieve than the “additional” return gained by simply investing in low-cost and low-tax index funds or similar vehicles, and once invested, by avoiding emotional mistakes like panic selling and chasing performance.

Most of the active versus passive statistics here compare one fund to another.  Of course, you can also buy individual stocks and bonds without any management costs and in a way that minimizes taxes.  Further, the discussion so far does not address which of the vast range of funds, stocks, bonds or other investments might be best from a mindful perspective.  This is the subject of the Article 6 on “What to invest in?”