There has been a decades-long “debate” around the merits of active (aka tactical) investment management vs. passive (aka indexing, strategic, or more accurately called evidence-based) investment management. We put “debate” in quotation because this is far from a real debate. If you eliminate the individuals and firms who make their living selling the dream of active management, there would be no argument. Passive wins hands-down.
In the simplest of terms, active management is the attempt to outperform the market averages through market timing, chart watching, stock selection or crystal ball gazing.
Passive management, or index investing, works by capturing the returns generated by the market. Opponents call this strategy boring, and the naysayers can often be heard asking “Who wants to settle for average?” The truth is that the average passive investor outpaces the average active investor by a sizable margin.
There are two primary explanations for the dominance of passive management—expenses and the efficiency of markets.
Expenses
Compared to the costs to run a passively managed fund or portfolio, active management is much more expensive. According to ICI Research, the average active equity mutual fund has an expense ratio of 0.68% and the average passive fund charges 0.06%. On top of this, active management carries a much higher cost of doing business because of the internal trading that is necessary to execute its activity.
In 1991, William Sharpe of Stanford University, and Nobel Prize in Economics winner, published The Arithmetic of Active Management, where he laid out the following argument:
- Before costs, the return on the average actively managed dollar will equal the return of the average passively managed dollar.
- After costs, the return of the average actively managed dollar will be less than the return on the average passively managed dollar.
Here is a hypothetical example of costs comparing the two strategies:
Passive Management/Active Management
- Passive Market return 10.0% Active Market return 10.0%
- Passive Fund expense 0.06% Active Fund expense 0.68%
- Passive Fund trading costs 0.10% Active Fund trading costs 0.96%
- Passive return 9.84% Active return 8.36%
Here is what a 1.48% difference makes on a $100,000 portfolio over time:
- After 10 years: $255,626 for passive vs $223,198 for active… a difference of $32,428
- After 20 years: $653,447 vs. $498,173… a difference of $155,274
- After 30 years: $1,670,382 vs. $1,111,911… a difference of $558,471
These are averages. Some active managers will do better, some will do worse. But a financial advisor’s job should be giving their client the highest probability of success, not taking chances or selling dreams.
Market Efficiency
One of the main arguments for active management is that with proper analysis and lots of brains, a good manager can do better than the market average. The problem with this argument is that it ignores the fact that investing is not two individuals battling it out; instead, it is one manager against every other investor out there. One person against the millions of traders who make the market efficient. There are so many smart people running funds that it is nearly impossible for one person to consistently be the winner. Often, it is the market that is the winner…the wisdom of the crowds!
The Proof is in the Numbers
SPIVA recently released their December 31, 2021 results for active manager performance. The results were, once again, not pretty. Here are the results for large cap managers vs the S&P 500:
- One year: 85.1% of managers underperformed
- 3 years: 67.9% of managers underperformed
- 5 years: 74.1% of managers underperformed
- 10 years: 83.1% of managers underperformed
So, a large cap investor had less than a 17% chance of beating the boring S&P 500 index fund over the past ten years. Passive wins in up years, down years, and flat years. The results are also similar for other asset classes including small caps, bonds, and international markets. It is difficult to fight against the relentless pursuit of humble arithmetic.
Wall Street Marketing
Wall Street and big banks have tried unsuccessfully to paint index investing as a “fad” or as “Un-American.” They can also be credited for creating the term “passive management” to convince investors that indexing is a “do-nothing” activity. They have spent billions of dollars to keep active management alive, often by paying financial “advisors” directly to sell their overpriced and underperforming funds. This helps explain why there are still investor dollars using strategies that have no merits of their own.
Wall Street’s marketing machine also explains why it is so difficult to get straight answers about active vs. passive investing. If “Retire Rich” magazine wrote about the merits of passive investing and the perils of active management or buying life insurance or annuities as investments, they’d be giving good advice but would lose rich Wall Street advertisers.
We’ve long warned friends and clients about clicking on what look like legitimate articles on the internet. Too often these articles are nothing more than sponsored content with an alternative agenda to sell high-priced and underperforming products.
Taxes
Before taxes, passive management wins every debate. After taxes, the argument isn’t even close. The activity of active management creates a tax burden for taxable accounts. Capital gains, including the dreaded short-term gains, are an additional cost to taxable investors that don’t show up on performance reports. Passive management, with its buy-and-hold strategy, has significantly less tax burden for the investor.
Which return would you choose?
Choosing between active and passive management can be described as having a random chance at any return from 1-10% or locking in an 8% return. Most rational people would choose 8%, but a salesman working on commission is going to question your intelligence for not wanting a chance to go for 9% or 10%, even though there is much greater chance of falling below 8%.
Implementation
Unfortunately, it takes a bit more than buying an S&P 500 index fund to implement a prudent and properly diversified portfolio. There are hundreds of index and passive funds and ETFs available and some are no better than active funds with their high costs. This is where having an advisor who works as a full-time fiduciary and embraces evidence-based investing is so important. Ask your advisor about the underlying costs to your investment portfolio. Anything over 0.20% per year (our clients average 0.11%) for fund expenses is a red flag that you’re paying too much.
Yes, the real debate is over, but Wall Street and big banks will keep it alive as long as they and their sales operation exist. Educated investors can avoid the Wall Street marketing machine and instead focus on life’s many blessings.
