Should you be a passive or active investor?
Passive investment, also known as indexing, buys a basket of stocks covered in an index and fund performance mirrors the overall movement of the markets. Active investment engages in stock research and screening and attempts to pick more winners than losers. Its performance will deviate from the market, above or below, depending on one’s skills — and some luck.
Choosing between passive or active investment is to choose between two ideologies — whether you believe market is beatable. Passive investors choose to be passive because they think active investment is much ado about nothing — it cannot beat the overall market returns.
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Do active-managed mutual funds as an industry have the ability to beat the market? Nobel Laureate William F. Sharpe suggests that active funds as a whole can’t beat the market, and shouldn’t. It’s as clear as one plus one equals two. Note that market return is a moving target. For any given year, the overall market return is the weighted average of the returns on the stocks in the market, and it varies over time. The whole market can also be viewed as the combination of two segments, passive and active. Naturally, the market return should be equal to the average of the returns on the two segments. Passive segment by design mirrors market return, then it must be true that active managers on average must earn market return as well. If not, the average of the two segments will not be the market return.
So how does the mutual fund industry do in reality? Do they deliver returns in excess of the market? Empirical evidence shows that, fewer than 16 percent of active mutual funds beat the benchmark returns by more than 1.25 percent a year. And fewer than 3 percent of the funds beat the market by 2.5 percent a year, before expenses. So the majority of the mutual fund managers fall short of the market. It seems that stock picking and market timing are rare skills possessed by only a few.
This is really bad news for active mutual fund investors. Because the active funds charge a much higher fee than passive funds in order to cover the management fees and transactions costs. If higher fees do not lead to better performance than the market, investors’ net of fee return will be less than the market. You would be better off being passive.
Now, how about the small group of funds that are able to beat the market? Can individual investors join in? Yes, but there are a couple of things to watch out.
First, identifying good managers will be a challenge. You need a long enough tracking record to tell skill from luck.
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Secondly, you need to pay attention to the fees. Even if the fund managers truly have the skill, you want to make sure that the skill generates enough returns to cover the fees.
Thirdly, since good managers are in short supply, they will be in high demand. As more funds flood in under their management, there will be diminishing rate of return — it will be harder and harder for the manager to beat the market. This happens because trading opportunities are rare.
Lastly, superb managers may not be within your reach. Better managers could be more selective in choosing clients. There are funds that require an investment threshold of $250,000 or $500,000, making it inaccessible to average investors.
All these combined reduce the appeal of active mutual funds. Indeed, indexing assets have increased from 24 percent to 32 percent from 2004 to 2014. Will the trend continue? Some think the capital markets will be doomed if everyone goes passive and no one assumes the responsibility of equity research and price discovery. You can rest assured that active investors will not go away. For activists, passive investment is just too boring, too pessimistic, and not responsible. It is in capital’s genes to always pursue “alpha” or excess returns. As long as mispricing exists, activists will aim high. They will take upon themselves to design strategies that can potentially beat the market. Human hubris will serve as a catalyst. Some managers will always believe that they are better than others.
How about non-professional investors? Vanguard founder Jack Bogle believes that individual investors shouldn’t even think of beating the market. Market returns with low transaction costs are exactly what average investors should seek. He has a point because the cost of active investment is especially high for individual investors. If you DIY your own active portfolio, you could suffer from a lack of diversification because of your limited budget. And if your stock picking skills are still in development, you could expose yourself to too much downside risk without enough upside potential.
[See: 10 Ways You Can Invest Like Warren Buffett.]
But one potential benefit of active investment missing in Bogle’s argument is the opportunity to learn. Stock research is fun and is a learning-by-doing process. If your goal is to become a shrewd investor in the long run, you need to start from somewhere. It is true that indexing is safer, but you do not learn anything by indexing. What you can do is to invest a portion of your money actively, and the rest on indexing. The passive part will give you the benefit of diversification, and the active part offers you learning opportunities. You can gradually increase the active portion as your become more knowledgeable and experienced.
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Pros and Cons of Passive and Active Investing originally appeared on usnews.com
