For instance, if an investor chooses to hold the S&P 500 index fund, widely regarded as a passive strategy, that investor is actively 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, which includes U.S. small- and mid-cap stocks, the U.S. bond market, international markets, etc.
Furthermore, any approach that uses multiple passive vehicles (index funds, ETFs, etc.) is, by nature, now an active strategy.
So the real genesis of the active vs. passive debate, and the question from our "Money Matters" listener, centers around performance. In short, which performs better? Is it true that the vast majority of active funds are bested by their index fund counterparts?
The real answer is that some do and some don’t. But it’s not nearly as one-sided as most headlines would have you believe. A Standard & Poor’s study recently highlighted 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 spectrum, a recent PIMCO/Morningstar study shows that the majority of active bond funds and bond ETFs do in fact beat their index fund counterparts. The data confirms 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 10 years. Interestingly, 63 percent of these funds beat their passive index peers over the past five years. The 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. This data is in stark contrast to the Standard & Poor's study, mostly due to how each study categorizes funds that are no longer in existence.
So, in reality, both active and passive investment vehicles have significant merit. Notice I said vehicles. Both active and passive vehicles can shine.
But there’s 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, 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 creates an uncomfortable “just live with it” approach.
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.” Rarely have I ever met an investor that has just ridden out the full ups and downs of owning one index fund through an entire market cycle; the emotional reality of this approach is almost always too much to bear.
So the questions to answer here are what approach to investing and what vehicles for investing will work best for you considering the extreme emotions that come with 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 combination of low-cost active and passive vehicles. This confirms my long-standing belief despite heavy-handed arguments from both sides of the aisle.
Wes Moss has been the host of “Money Matters” on News 95.5 and AM 750 WSB in Atlanta for more than seven years now, and he does a live show from 9-11 a.m. Sundays. He is the chief investment strategist for Atlanta-based Capital Investment Advisors. For more information, go to wesmoss.com.
This information is provided to you as a resource for informational purposes only. It 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. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. 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.