The active versus passive investing debate continues to rage in the popular business press. The Wall Street Journal recently ran a week-long series exploring the origins and value of passive investing.
This debate misses two key points.
- Asset allocation, not how your funds are managed, overwhelmingly determines your portfolio’s performance.
- Human behavior affects a portfolio’s performance. Don’t buy high and sell low: continue to invest in market down turns, don’t chase returns, and rebalance your portfolio annually. Avoiding some bad actions makes a big difference.
Nonetheless I’ve summarized the takeaways from the WSJ series. I also discuss how you can use passively managed funds in your portfolio.
What is Passive Investing?
Passive investing involves investing in mutual funds (or Exchange Traded Funds (ETFs)) that track indexes of the stock or bond market. The fund doesn’t beat the market’s return. Rather it delivers the market’s return minus a very small management fee. Expense ratios are in the range of 0.1%. These types of funds are called “index funds” because they track a market index.
Active investing generally involves picking stocks the manager expects to “beat” the market. Actively managed funds have higher expense ratios due to frequent trading in the fund. They also have greater salary expenses for marketing and research. Actively managed funds have expense ratios around 1.0%. This expense lowers the fund’s return.
Recent investigations show that nearly 85% of actively managed mutual funds do not beat their market indexes over time. Not surprisingly more investors have moved out of actively managed funds to passively managed ones.
The Knocks Against Passive Investing
Many active manages couch their case for active management as a way to protect against downside risk. In other words, actively managed funds can protect you when the market falls.
If the market craters so does your passively managed fund. Active management, so the theory goes, can protect against the downturns.
But another way to protect against market downturns is to diversify your holdings into asset classes that do not move together. That is, they are not positively correlated.
You can invest in non-correlated asset classes by holding both US and international stock and bond index funds. Your portfolio’s asset allocation can guard against down turns in any one market segment.
The second knock against passive management is that these funds are over-valued because of the price premium for the companies in the fund. This argument is especially prevalent if the index is narrow – such as the S&P 500. This index identifies 500 top US companies. Mere inclusion in the index raises the stock price as more index funds demand the stock.
You can avoid this problem by investing in broader indexes of the market. Use a total stock market fund or a total bond market fund.
The third knock against passive investing is that there are some really good actively managed funds available. Some have suggested that active funds with low expenses and a substantial amount of management’s own money invested in the funds produce above market returns.
It is difficult, however, for an individual investor to find these funds without paying a large fee to a financial advisor. The fee, by the way, would probably negate the better returns these funds produce.
I’m a proponent of passive investing in broad-based mutual funds. If you want to diversify even more, you can supplement your passively managed funds with a small amount of actively managed ones in narrow market segments where seasoned managers have proven results, such as emerging market bonds or real estate investment trust. But you won’t go wrong with a passive investing approach for the bulk of your portfolio.