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Active vs. Passive Investing

Novice and experienced investors, when first introduced to passive management tend to dismiss it. How can a strategy to buy and hold every stock deliver higher-returns than only selecting the best stocks to invest in? You would think that some companies with better prospects than others would be more profitable investments. Shouldn’t analysis by skilled researchers deliver superior results? This is a total misconception.

Embraced by many of the world’s largest investors passive investing has overcome enormous skepticism.  In the 70’s researchers armed with powerful computers began assembling a detailed history of security prices and tested assumptions that had never been thoroughly evaluated before. The superiority of active management was one of the assumptions that researchers tested for.

At traditional investment firms, research analysts, portfolio managers and traders have access to piles of in-depth reports advising which stocks to buy or sell, and industries to overweight or avoid altogether. Is the effort worth the cost compared to a simple strategy of holding a market portfolio of stocks? When the key question is whether the information is already incorporated into market prices, unfortunately, skill in evaluating the business prospects of a firm or the outlook for an industry is not sufficient for successful trading.

Active Managers Underperform Passive Managers

Audited by professional accountants and publicly available for all to see,  mutual fund returns are a good source of data on the effectiveness of active manager efforts.  For the five-year period ending December 31, 2010 Standard & Poors (S&P) reports that only 37% of large cap core funds outperformed the S&P 500 Index on an annual basis.  Results were even less favorable for non-US markets. Just 18% of international funds and 10% of emerging markets funds beat their benchmarks. It’s often said that foreign stock markets contain more pricing errors than the US market; supposedly giving clever stock pickers plenty of opportunity for beating the market. The performance data published by S&P suggests in reality this is more often fiction than fact.

Fixed income (bond) markets  pose even more of a challenge: for the same five-year period, Standard & Poors found that only 25% of short-term government funds were outperformers, only 14% of general municipal debt funds were outperformers, and the number of outperformers dropped to 8% for high-yield bond funds and only 3% for short-term investment grade funds.

Consistent superiority has been even a tougher challenge for active managers: Few bond funds consistently repeat top-half or top-quartile performance within the category.  Over the five years ending September 2010, S&P reported that only 4.10% of large-cap funds, 3.80% of mid-cap funds, and 4.60% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. If 4.1% of the funds were able to beat the market consistently isn’t that evidence that a minority of active managers are genuinely skilled? Not necessarily. According to Standard and Poors a random outcome would give you a rate of 6.25%. In other words the number of funds outperforming the market is no greater than one would expect by chance.

Some people believe that during a bear market active management has a distinct performance advantage based on its ability to quickly shift into cash or defensive securities. Again, nothing could be further from the truth. Standard and Poor’s found that a majority of active funds underperformed their indices in the negative markets of 2008. Over the five year market cycle from 2004 to 2008, S&P 500 outperformed 71.9% of actively managed large cap funds, S&P Mid Cap 400 outperformed 79.1% of mid cap funds and S&P Small Cap 600 outperformed 85.5% of small cap funds. These results are similar to that of the previous five year cycle from 1999 to 2003.

According to the S&P report the story was similar for foreign equity funds, with the majority of actively managed non-U.S. equity funds underperforming benchmarks over the five year market cycle from 2004 to 2008. What about bond funds? Benchmark indices outperformed a majority of actively managed fixed income (bond) funds over the 2004 to 2008 horizon as well. Five year benchmark shortfalls ranged from 2%-3% per annum for municipal bond funds to 1%-5% per annum for investment grade bond funds.

Why Should Outperforming An Index Be So Difficult?

The investment industry attracts bright, highly trained, and hardworking people. So why can’t they outperform an index?  Maybe high management fees are to blame with fund companies more concerned about increasing their profits rather than improving investment results. This criticism is valid, but it misses the point. The insinuation is that managers could easily outperform their benchmark if they weren’t so greedy. If this were true, major pension funds, who negotiate low fees would show better performance results. But even among these sophisticated investors, the record of active management compared to passive strategies is unimpressive.

Internally, active managers often explain their mediocre performance by pointing to their size. They are unable to fully implement their research ideas because as they execute their transactions, stock prices tend to move away from them. Treynor (1994) points out that bid-ask spreads and prices pressures from the adversarial nature of the trading process give rise to implementation shortfall.

What can explain the failure of traditional active managers to perform better?  Just as aluminum, gas, or timber prices rapidly incorporate new economic developments, so do financial asset prices. At any given moment, stock and bond prices represents the best estimate of their fair value by investors. Do some companies have better a outlook due to brand name recognition, superior technology, unique selling position, or financial strength? Absolutely! And this optimism is reflected in higher stock price relative to other companies as prices adjust to new information. But since news is unpredictable so are stock prices.

To construct a market beating portfolio, active managers must identify miss-priced stocks. They must have accurate information that other investors don’t know about yet. To profit from this insight, other investors must then act upon this information, causing the mis-pricing to be corrected. In a world where information is rapidly distributed, and use of insider information is illegal, identifying miss-priced stocks is a tall order. Gaining an advantage over other investors in a competitive market place is challenging. To be successful, active manager must regularly find miss-priced securities. The failure of active management to perform better is solid evidence that capital markets are functioning efficiently.

Active Funds Are Expensive To Own

Unlike passive investors, active investors pay heavily to participate in actively managed funds. Fees and expenses vary from fund to fund and can take a huge bite out of returns. Some costs such as portfolio management and administrative fees, trading commissions, and ongoing 12b-1 fees intended to cover fund marketing and advertising expenses are hidden or obscured by the fine print in the back of prospectuses. Even small differences in fees can translate into large differences in returns over time. For example, if you invested $10,000 in a fund with a 10% annual return before expenses and annual operating expenses of 1.5%, after 30 years you would have about $115,582. But if the fund had expenses of 0.2%, you would end up with $165,223, a 43% difference. Bottom line, high investment costs, the byproduct of active portfolio management are as much a threat to investment returns as inflation and taxes. The main point is that any portfolio with fewer costs has a higher expected return. And because this is true, actively managed mutual funds would need to deliver the impossible and outperform the market every year just to break even with their low cost passive counterparts.

The Advantages Of Passive Investing

When adjusted for common risk factors Index mutual funds consistently produce rates of return exceeding active managers by close to 2 percent.  This excess performance is chiefly explained by management fees and trading costs.  Actively managed mutual funds charge annual management fees that on average total approximately 150 basis points (1 ½ percentage points).  Furthermore, index funds trade only when necessary (since passive managers aren’t active traders), whereas active funds typically have a turnover rate of close to 100%, and often significantly more.

Index funds are also tax efficient. Index funds allow investors to defer realization of capital gains or avoid them entirely if shares are later passed to heirs. To the extent that the long-term upward trend in stock prices continues, active trading from one security another entails realizing capital gains that are subject to tax .Taxes are a critically important issue because realization of capital gains significantly reduce net returns. Index funds tend to minimize capital gain taxes because they do not trade from security to security.

Index funds are also relatively predictable. When you buy an actively managed fund, you can never be sure how it will perform relative to its peers. When you buy an index fund you can be reasonably confident that it will track its index and that it is likely to outperform the average active manager. Moreover, index funds are always fully invested. Be skeptical of the active manager who claims that his or her fund will move into or out of cash at the correct times. Research shows unambiguously that market timing does not work. With index funds, you know exactly what you are getting. The passive investment process is straightforward. Broad diversification and low costs due to low turnover and low management fees reduce risk and provide long-term insurmountable return advantages for the passive investment process over any form of active management.


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338 Via Vera Cruz, Suite 240, San Marcos, CA 92078
Phone (760) 635-7526
Toll Free (888) 332-2238
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