For as much as I talk about passive investing, I never wrote a post discussing the differences between active investing and passive investing and the advantages and disadvantages of both. All of that is about to change however, as this post is going to do just that! So here is everything you ever wanted to know about active and passive investing and all of the advantages and disadvantages of each.
What is Active Investing?
Active investing involves the ongoing buying and selling of securities by an investor. An investor that follows the beliefs of active investing is continuously buying and selling in hopes of exploiting profitable conditions in the stock market.
In other words, an active investor is simply trying to outperform the market. For example, if a fund manager runs an active investing mutual fund that invests in large cap companies, such as General Electric, IBM, Microsoft, etc. his goal is to outperform the S&P 500 Index. This index is the one that tracks these large cap companies.
If you look at a mutual fund prospectus, you will see in there the benchmark, or market, which the mutual fund is trying to outperform. In most cases, you will see graphs comparing the mutual funds return to that of its benchmark.
Advantages of Active Investing
Now that we know the goal of active investing, what are the advantages of investing this way? Here the benefits, in no particular order:
Potentially Higher Returns: Since the investor/manager is trying to beat the market, there is the potential for higher returns than that of the market if they are successful.
Expert Analysis: Most individual investors don’t have the time or funds required to create and maintain a diversified portfolio made up of individual stocks. The fund manager in this case solves these problems.
Defensive Measures: Since an active manager is always monitoring the portfolio, should the market take a downturn, the manager can take defensive measures. This would include moving a percentage of the fund’s assets to cash or investing in better performing investments.
Disadvantages of Active Investing
Fees: Fees for investing in actively manages funds are higher than that of passive investing fees. Because of this, an actively managed fund has to earn more than the market, plus the fee it charges to investors to have beaten the market. More on this later.
Markets Are Efficient: For the most part, the stock market is efficient. What does this mean? It means that at any given time, all of the information is already priced into the market. In other words, it is hard to exploit the market. Because of this, it is hard for a manager to consistently beat the stock market.
Less Tax Efficient: In many cases, an active investing philosophy is very tax inefficient. The manager is not concerned with limiting the tax consequences of his or her actions. They are solely interested in outperforming the market. As a result, investors could face a higher tax bill from all of the realized capital gains.
What is Passive Investing?
We now turn our attention to passive investing. Passive investing involves limiting the continuous buying and selling of investments and instead, holding onto investments for long-term appreciation.
In other words, a passive investor is more interested in the long-term growth of their portfolio and limiting the maintenance that surrounds investing. A passive investor is not concerned at all with trying to beat the market or index that the underlying fund is tracking.
Therefore, using the example above of a fund manager running a fund that consists of General Electric, IBM, Microsoft, etc., a passive manager is simply trying to match the benchmark. Again, in this case it is the S&P 500 Index. They will do this by primarily investing the same funds and weightings that the index holds. Since these holdings rarely change, there are very few trades that the fund manager makes.
Advantages of Passive Investing
Lower Fees: Since the manager isn’t actively monitoring the fund and making trades, the management fees for passive investing are lower than active management fees.
Little Action Required: Since the manager isn’t making many trades, there is very little action that needs to be done. This spills over to the individual investor as well. Once you set up your diversified portfolio, 99% of your work is done.
Tax Efficient: Since there are so few trades, investors in passive funds do not get large tax bills from their fund companies. Fewer trades mean fewer chances of taxable capital gains.
Disadvantages of Passive Investing
Unlikely to Outperform The Market: Chances are, your passive investment isn’t going to beat the market very often.
Lack of Control: A passive investment performs the same as the index it tracks. When the market is up, so is your investment. But when the market is down, so is your investment.
Can’t Take Action: When the fund manager sees that the market is dropping, they cannot take defensive action and move some assets to cash. Likewise, they cannot sell certain holdings to curtail the losses.
Which is Better: Active or Passive?
You already know that I am biased towards passive investing, so I am going to tell you that the answer is passive investing. I have personal experience with both types of investing. When I first started out investing, I was an active investor. I was buying and selling, trying to earn the highest return possible. That is all I cared about.
When I sat down and looked at how much I was paying in fees and what my actual returns were, I was shocked! I started to look into alternative ways to invest my money and stumbled upon the idea of passive investing. Not only does a passive management approach cost much less in fees, I’ve learned that performance wise, you are better off taking what the market gives you.
According to research by CRSP, roughly 25% of actively managed mutual funds beat their benchmark year in and year out. Twenty-five percent! I don’t know about you, but those odds aren’t attractive to me. I’d rather take what the market gives me. It’s not worth it to me to pay a higher fee every year in the off chance that I am going to outperform the market.
Why Can’t Actively Managed Funds Win Consistently?
So why is it so hard for actively managed funds to beat their benchmark consistently?
- First, it all goes back to the idea of the market being efficient. It’s not easy to pick winning stocks every single year. You might get lucky here and there, but you won’t be able to do it consistently. No one can, and those that tell you they are, are lying. The only person in recent history that has done so is Bill Gross at Putnam. He beat the market every year from 1991-2005. He admitted his winning streak was more luck than skill. He has since beaten the market only a handful of times. (And the odds of a similar winning streak: 1 in 2.3 million.)
- Secondly, the higher fees eat into the actively managed funds returns. Look at it this way: If you have the index returning 8% per year, the actively managed fund cannot return 8.1% and beat the market. You have to take into account the management fee of the fund. In most cases, that fee is roughly 1%. So the actively managed fund has to return at least 9.1% just to beat the market. Every year, that fund has to return 1.1% better than the market. It doesn’t sound too difficult, but it actually is.
Why Invest With Passively Managed Funds?
Here is why I suggest you invest passively.
- First off, the expenses are lower. In the example above with 8% returns, the passively managed fund only needs to return 8.3% in order to match the market since its management fees are so much lower – 0.30% in this case. Remember, you pay these fees even though you don’t get a physical bill for them.
- Next, I hate taxes. By investing in a passive fund, I pay less in capital gains taxes. Avoiding capital gains is an easy way for me to keep my tax bill in check.
- Third, I like the fact that I don’t have to consistently monitor my investments. I know my investments are coming close to matching what the market is giving. I basically put my investments on auto-pilot. I still check in on them occasionally, but I don’t have to make it a point to monitor everything. I don’t have time for that.
- Lastly, I choose passive investing because I don’t like the odds of only beating the market 25% of the time. Sure, when the market drops, so too will my investment, but odds are, that even if I was investing in an actively managed fund, I’d lose money too. So why then am I paying a higher fee? Paying the premium for a shot at a higher return doesn’t make sense to me. (Some might try to argue that an active fund might lose less than the passive fund in a down market since the active manager can take defensive measures. While this is true, it doesn’t matter to me. I see a market pull back as a buying opportunity and I hold for the long-term. Therefore, I’d rather lose more in a given year and pay a lower fee than pay a higher fee and hope the fund is able to reduce some losses.)
If you are currently an active investor, I suggest you try out Personal Capital. It’s a free investment account aggregator that will allow you to see all of your investment accounts in one place. It’s completely free to use and you can get it on both your Smartphone and tablet.
The reason I suggest it is because once you enter in all of your investments, you can see how much you are paying in fees. I guarantee this will open your eyes to how much money your investments are costing you. Plus they have great interactive charts for you to play with. I find myself logging one at least once a day.
Next, I suggest you look into a firm like Betterment. It’s an investment company that invests your money in low cost ETF portfolio’s for a super low fee. I personally invest with them and think they are great. You can read my review of Betterment here, or click here to sign up. If Betterment doesn’t sound like an option to you, check out my online broker comparison chart to find an investment firm that meets your needs best.
Finally, some of you might be scared to invest in the stock market. I encourage you to learn all that you can about investing so that you have a better understanding of how it works. I feel that much of the dislike for the stock market is simply a lack of education on how it works. Plus, I think this is why so many people have such lousy returns.
There are advantages and disadvantages to both active investing and passive investing. I feel that the advantages of passive investing outweigh the disadvantages. I started investing with a passive mindset years ago with only a few hundred dollars and I’ve turned that into a six figure portfolio – and that includes the crash in 2008. I didn’t just say that to brag, I said to prove a point. If you invest wisely, through low cost funds and stay invested for the long-term, you will be a successful investor.
I’m interested to hear your thoughts and comments on this subject. What are you for, active investing or passive investing?