The Great Debate Continues: Active vs. Passive
In sports, music, and politics, there are “great debates” that never seem to conclude. In the investment world, one great debate asks a thought-provoking question: which investment approach is better – Active or passive?
Equally intelligent, educated people can take distinctly opposite sides in this discussion, which may mean no definitive answer exists.
Passive pointers. The case for passive investment management is anchored in the evidence that the preponderance of money managers has failed consistently to beat their comparative index. Why is this? Adherents of passive investing cite two primary reasons:
One, markets are efficient, and all known information is already reflected in the price of the stock, making it difficult for managers to find companies that are expected to outperform. Over the 15 years ending in 2017, more than 90% of small-cap, mid-cap, and large-cap asset managers of active equity funds failed to beat their benchmarks. Some did for a particular year, but across successive market years, their ranks quickly thinned.[i],[ii]
Two, actively managed equity funds often have an elevated expense ratio. That presents a hurdle, which can make it hard to match or exceed the return of a low-expense index fund. In 2017, actively managed funds had an expense ratio averaging 0.79%, according to the Investment Company Institute (ICI), compared to 0.09% for the average equity index fund.2,[iii]
Even so, a studious investor has to decide if the potential cost savings of a passive investing approach outweigh the possible opportunity cost.
Active arguments. Active investment managers counter that while the markets may be generally efficient, there are windows of inefficiency created by the time it takes for information to be properly reflected in a stock’s price.
Active managers further argue that performance is not just about relative return, but also, about managing risk. Since the performance of an actively managed account or fund is not tracked to an index, that freedom allows the manager more leeway and options to hedge or reduce exposure to disappointing sectors of the market.
Unlock the combination. Ultimately, the active vs. passive decision comes down to preference. Do you prefer the approach taken by index funds or the strategy behind active management? For some, the combination of both methods represents a strategy that takes no sides but seeks to tap into the distinctive potential benefits of each method. Some investors choose to have a portion of their invested assets actively managed and another passively managed. Perhaps this is not indecision so much as experimentation.
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[i] https://www.investopedia.com/ask/answers/032615/what-are-differences-between-weak-strong-and-semistrong-versions-efficient-market-hypothesis.asp
[ii] http://www.aei.org/publication/more-evidence-that-its-very-hard-to-beat-the-market-over-time-95-of-financial-professionals-cant-do-it/
[iii] https://www.thestreet.com/investing/etfs/expense-ratio-14686652
