When Active Investing Beats Passive Investing

Posted by Alex Frey (@alexhfrey )

Do you want to be an active investor, or a passive investor? It's an elementary question that anyone getting started with investing has to be able to answer. 

But what does it really mean to invest "actively" or "passively," and is there such a thing as being "in between," or do you have to fall at an extreme?

These are some of the important questions being posed by the ETF revolution. And it turns out they don't have particularly clear answers. 

Getting Defintional: Active vs. Passive Investing

First, some definitions, since they actually aren't as obvious as they seem. "Active management" refers to the strategy of attempting to pick investments that will perform better than the overall stock market. Mutual fund managers that select individual stocks on the basis of fundamental research are classic examples of active managers.

Passive investing refers to the strategy of attempting to "match" the market, and is closely related to the idea of "buying and holding." Only instead of buying and holding individual stocks, investors may be buying and holding entire markets through funds that track indices such as the S&P 500, a group of 500 large cap US stocks. 

Why the Passive Investing Revolution Has Been Good for Investors

In recent years, passive funds that try to match the market (and often charge very low fees) have taken massive share from active funds that try to beat the market (and often charge very high fees). 

Overall, this has been a very positive development for investors, for two reasons. 

First, the passive investing revolution is saving individual investors a lot of money. In the past, investors habitually spent billions of dollars a year in fees in exchange for pretty sub-par performance. As one example, roughly 90% of mutual funds failed to beat their passive benchmarks over the past three years. That means that 90% of all mutual-fund investors would have been better off in low-cost ETFs instead (see "The First Grand Theory of Investing"). With a shift to passive funds, more investors are spending less and getting more. 

Second, when investors take a passive approach to investing, they naturally start to shift their focus to the things that are actually important. The essentials of investing should be no strangers to anyone that has spent more than a minute on this site: build a diversified portfolio, get your asset allocation right, keep expenses low and stick to your game plan. These essentials all too often get overshadowed by their sexier second-cousin: stock-picking. But the passive investing revolution is helping to put the focus where it should be - on the factors that account for 95% of the average investor's returns. 

What Passive Investing Still Gets Wrong

The problem with passive investing is that it is not quite as clear how to follow a truly "passive" investment strategy as it might first seem.

At first, this statement seems like it might be a little bit unfair. It is quite simple, for instance, to decide that instead of purchasing Apple stock you are just going to buy the entire US stock market using a Vanguard ETF (and pay a stunningly low .05% of your investment in expenses for it...).

But, if you just buy and hold a single ETF that tracks the broad US stock market, your portfolio is going to go through some pretty big whipsaws, like the 2008 collapse (see "A Strategy to Stay Ahead of the Herd"). Moreover, you are not really getting the free lunch of diversification, because this portfolio is extremely concentrated in stocks, and in a particular geography.

Furthermore, when you add commodities, foreign stocks, emerging markets stocks, Treasury bonds, and real estate into the mix, it is no longer particularly clear just how much to invest in each, or what the "passive" answer to that should look like. 

A supposed "passive" answer to this is to use something called "modern portfolio theory" to calculate a neutral portfolio that is appropriate for you. However, modern portfolio theory rests (among many other assumptions) on the idea of there being an "efficient market," which would mean that current market prices always perfectly reflect reality (see "Here's Where You Might Be Defying Common Sense...").

Academic evidence now strongly suggests that this is not true. But never mind the academic evidence. The fact of the matter is that few sane people that have lived through the last 15 years can really believe in an efficient market.

MPT is so popular because it provides a very precise mathematical formula to determine what your portfolio allocations "should" be -- down to the decimal point. Unfortunately, you have to plug "expected future returns" into the formula in order to get the "answer." Further, there is no place to find "expected future returns" in a newspaper. This slight problem is solved by using historical returns instead.

But, let's stop for a moment there, because plugging historical returns into that formula in place of expected future returns might sound a lot like making a bet. And it is. In fact, it is making a bet that the past will repeat itself. This doesn't sound very passive. It also doesn't, for a lot of reasons (drastically different valuations between the starting point and today, totally different historical circumstances, I could go on...), sound like a very good bet.

In the end, our view is that passive investing is a welcome development, but an unfortunate term. It is a welcome development, in that it has provided a popular alternative to investing in ineffective mutual-funds. It is an unfortunate term, because there is no such thing as a truly passive investing strategy. Every strategy must tackle the question: what assets should I buy today? And there is not a totally passive way to answer that. 

An "Actively Passive" Strategy

While a purely passive strategy might be impossible, this does not mean that there are not important things to learn from passive investing. We think the best of both worlds is to use an actively-managed ETF strategy. This strategy is "active" in the sense that it adjusts its allocations to stocks, bonds, real estate, commodities, and gold based on market conditions, but it is "passive" in that it uses broad ETFs to "match" each of these markets, rather than trying to "beat" them by picking individual securities. 

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By Alex Frey