Investment Strategy - Passive vs Active
Posted by John Posey
Are you familiar with the difference between an active and a passive investment strategy? Here’s a quick summary. An active approach involves buying and selling securities to manage risk and attempt to improve performance over a comparable benchmark. Alternatively, a passive approach generally attempts to replicate a benchmark or specific category of investment often weighting underlying securities to their market capitalization (ie – underlying investments are allocated relative to their size represented in the market, index, or applicable category of investments). In other words, active strategies often buy and sell throughout the year and passive strategies buy and hold. I have no prejudices, I like both!...well, sometimes. :)
There is compelling evidence that most active equity (stock) mutual fund managers overwhelmingly do not outperform respective market indexes or benchmarks, which I’ve highlighted in the Financial Freedom Field Guide based on research compiled by Vanguard (see their report, Keys to Improving the Odds of Active Management Success). This has led to much debate on the merits of active investment strategies over the years even to the extent that some have villainized the broader mutual fund industry for underperformance and much higher fees relative to the passive index fund and exchange-traded fund alternatives designed to simply track market index performance. Given the evidence, I think it makes sense to use more passive investment options the longer your time horizon and the higher the allocation to large and efficient areas of equity markets, such as US Large Cap funds for example. Not to mention, passive investments are often much more tax-efficient relative to mutual funds which becomes an increasingly significant consideration the more non-retirement investments you own. Having to report taxable capital gain distributions particularly when you did not personally request a sell from non-retirement mutual fund holdings can become an unwelcome surprise come tax time and can derail valuable tax planning opportunities. Anyone with a sizeable amount (say north of half a million for example) in non-retirement investments held in active mutual funds has likely felt the tax sting before.
In short, I think passive equity investments often provide a more compelling investment solution with low to no fees and broad equity market participation that I expect will provide attractive results to disciplined long-term investors. With that said, I think there can be a prudent time and a place for an active approach in some areas of the global equity market, particularly where information is less transparent and possibly results in a less efficient market, perhaps in a category like foreign emerging markets. At the end of the day, no one can know with any precise degree of certainty which approach will provide a better outcome at any given moment. In any event, it’s wise to keep your decisions weighted on the evidence.
Interestingly, the passive investing story isn’t the same for active fixed income (bond) mutual funds. There is evidence to suggest active bond fund managers tend to outperform their respective benchmarks. Guggenheim published an interesting article on the topic, The Risk Mitigation Advantage in Active Fixed-Income Management. There are several explanations to why active fixed income strategies often perform better than passive but I suspect it is primarily because it seems there are unique factors at play in fixed income markets for active managers to more effectively hedge or capitalize on. There are also some design pitfalls of passive bond funds including difficulty replicating an index as some bonds are not necessarily available for purchase on any given day. Additionally, the composition of many fixed-income indexes often reflects a weighting that is skewed towards the largest debtors which may not give us the feeling of security we were searching for. Furthermore, it isn’t possible to manage interest rate risk and duration using a passive approach which could be significant going forward as many anticipate a rising interest rate environment in the years to come.
As with most investing, time has the unique ability to disguise ill-timed investments and short-term price volatility the longer the time horizon, so I expect using passive fixed income is a relatively harmless approach over the long haul. However, considering the evidence presented I’m not convinced using passive fixed income is worth the tradeoff of lower fund costs particularly for the retiree demographic that often places more value on liquidity and security. I particularly don’t like the passive fixed income idea for investment portfolios being relied on to meet retirement income needs including irregular lump sum needs that seem to inevitably arise from time to time. Passive fixed income could make more sense for a younger investor yet many younger investors don’t often have a desire or need for much in the way of fixed income for long-term investments so I don’t view passive fixed income as a very compelling strategy for most. And as a side note, let’s also remember that the majority of fixed-income investments are not wealth creators but wealth preservers at best assuming their results can outpace inflation. The investments that move the needle in terms of our future wealth will come from equities.
So which is better – passive or active? The evidence suggests to me that a passive strategy will often be a better option for most equities and an active strategy will often be a better option for most fixed income. There can be some exceptions to the rule, but by and large, that’s the moral of the story.
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