It’s hard to believe, but we’re more than halfway through 2018. So far, it’s been a year of market ups and downs. We’ve endured a correction, experienced a rebound, and are now back closer to flat. The recent choppiness makes this a good time to revisit the great debate between active and passive investing.
Last year, an email from a listener to my “Money Matters” radio show posed a question of particular relevance now, as we head into the second half of the year. “Wes,” she asked, “is it time for me to become a passive investor?”
She had been using active mutual funds for years and wanted to rebalance her portfolio using passive investment vehicles. Her question likely applied or will apply to most of you at some point.
Before we get into the nitty-gritty of my answer, let’s define active investing versus passive investing.
Passive investing, by strict definition, entails owning the market or a broad market index fund and never trading it. Remember, you can’t own an index, only a fund that attempts to track an index.
Active investing is anything besides a pure “buy and hold” strategy of a particular index fund.
There really is no such thing as pure passive investing, just various shades of active investing. More on this later.
For now, consider the example in which an investor chooses to hold the S&P 500 index fund. This is widely regarded as a passive strategy. Remember, however, this investor is choosing to hold only U.S. stocks. This is actually an active decision to only invest in about 10 percent of the world’s more than $240 trillion investable marketplace. Under our logic, then, any approach that uses multiple passive vehicles (index funds, ETFs, etc.) is, by nature, an active strategy.
So, the root of the active vs. passive debate and the question from our radio listener revolves around performance: Which performs better? Is there any truth to the belief that most active funds are bested by their index fund counterparts?
Some index funds do outperform active funds and others don’t. It’s not nearly as cut and dried as most headlines would have you believe.
A recent Standard & Poor’s study featured in The Wall Street Journal claims that more than 90 percent of actively managed large-cap equity funds underperformed their index over the past 15 years.
On the other side of the argument, a recent PIMCO/Morningstar study shows that the majority of active bond funds and bond ETFs do beat their index fund counterparts. The data confirm that in most bond categories (short-term, high yield, intermediate, etc.), index funds trailed their active-fund counterparts over the past one, three, five, seven and ten years.
Interestingly, 63 percent of these funds beat their passive index peers over the past five years. The PIMCO/Morningstar study goes on to show that stock (or equity) mutual funds don’t fare quite as well against their passive competition. But, about one-third of active stock funds do best their passive competition on a one-, three-, five-, seven- and 10-year basis.
So, both active and passive investment vehicles have significant merit. But there is a distinction to be made between the vehicles that we use as investors, and how our overall investment strategy or approach is defined.
This brings me back to my earlier point: There really is no such thing as pure passive investing. There are just various shades of active investing.
Very few investors feel comfortable applying a fully passive investment approach. Simply investing in an S&P 500 index fund or one of the many hundreds of index funds that track indexes around the globe can be nerve-racking. The same is true for anyone operating on the purely active investment extreme.
Most people just aren’t comfortable at either end of the spectrum: It’s draining to experience the full brunt of the market fluctuations and the resultant emotional fluctuations. Operating on either pure end is difficult to do and still remain on course. Instead of being black-or-white investors, most of us fall somewhere in a gray area of active-passive investing.
Empirical data from Dalbar shows that the majority of individual investors have little tolerance for dramatic market moves, which leads to ill-timed buying and selling, otherwise known as poor “market timing.” I’ve known very few people who could handle the ups and downs of owning one index fund through an entire market cycle: The emotional strain of this approach is almost always too much to bear.
The real questions to answer here are what approach to investing and what vehicles for investing will work best for you when we consider the tumultuous emotions that accompany watching your hard-earned money rise and fall with the irrationality of world markets.
After meticulously reviewing the most recent data on active vs. passive investing, I have come to the following conclusion: Most investors, including our “Money Matters” listener, will benefit from a broad array of low-cost index funds, low-cost active funds, and ETFs that cover several different investment categories, while considering their tolerance for risk.
This approach creates a balanced portfolio somewhere in the gray area of the passive-active continuum.
This information is provided to you as a resource for informational purposes only and should not be viewed as investment advice or recommendations. Investing involves risk, including the possible loss of principal. There is no guarantee offered that investment return, yield, or performance will be achieved. There will be periods of performance fluctuations, including periods of negative returns. Past performance is not indicative of future results when considering any investment vehicle. This information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax, or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.