Passive Investing

Active vs. Passive Investing

There is an on-going debate between active and passive management. Passive management, also known as “indexing” refers to an investment approach that attempts to make no distinction between attractive and unattractive investments. It seeks to match the risk and return of the market without forecasting prices. Investors of this strategy often invest in portfolios that mimic the return and composition of index funds and/or asset classes. An index fund is a way of investing money that attempts to imitate the performance of particular financial market. One of the largest is the Vanguard 500 Index Fund which is designed to track the S&P 500®. Working with historical data, passive investors can estimate risk with each asset class and properly assign a plan that fits the client’s risk-tolerance.

Active management is a strategy where investors attempt to use market-timing and information of specific investments to outperform a benchmark, or in other words “beat the market.” This strategy uses a variety of in-depth methods which the investor attempts to achieve to above-average returns. A few of the major strategies employ methods using value, growth, growth with value and income. We break the various strategies into eight equity categories with dozens of different sub categories. Examples of those strategies may include a bottom up investment process which is an analysis of an individual company to decide if it is worthy of investment. Top down investors look at the overall markets and specific industries and securities that are currently doing well or that have the potential to grow. With passive management, an investor may estimate risk levels, however with an active approach, risk may seem more ambiguous because of constant change in the asset allocation.

Overall returns

The theory of passive management became popular at universities and institutions. Novice investors began to dismiss the strategy. However, a significant amount of evidence from research made it apparent that passive investment generally outperforms active strategies. Most mutual funds cannot beat their benchmark, which is an index that a manager uses for comparison purposes. Some might wonder how the passive method surpasses returns of a portfolio that is continually selecting what seems to be the most attractive investments. In 1964, American economist Michael Jensen began a study of the performance of mutual fund managers compared to the performance of the market covering a period of almost 50 years. It reported that only 48 out of 115 mutual funds outperformed the market excluding the management fees. These fees are weighted heavily in an active management scheme. After the fees have been subtracted, the new returns, the ones the shareholders actually receive, show that the number of funds that beat the market decreased to 39 out of 115. Although it seems active management may have a chance of outperforming the market, an issue of consistency becomes visible. Last year’s top performers may exceed the market by .25% this year, but over time the excess is diminished. Dozens of studies following Jensen’s continually support these findings.

Markets Are Efficient

In order to beat the market, active management strategists most properly identify mispriced stocks that will become winners. Investors must receive exclusive, accurate information and hope other investors do not obtain it. The price must then change at a future date to reflect this information. This event where an investor attempts to successfully time the market is inherently riskier. One theory of why passive management is superior is because of the efficient market hypothesis (EMH). EMH establishes that all information regarding the investment is already integrated into the price and that it is nearly impossible to outperform the market. There are too many skilled managers analyzing the market for an investor to continually have an advantage.

Realized Costs of Active Management

We must recognize that active management suffers from increased costs. Every dollar towards these costs is a dollar taken from the return. Transaction costs from this strategy are many and staggering. Some transaction costs from fund management include advisory fees, administrative fees, commissions through revenue, bid/ask spread and market impact costs. Also known as soft dollar fees, brokerage fees paid through commission are viewed negatively by the public. The fees may not be as apparent as hard dollar costs. In active management, soft dollar fees can accumulate quickly with frequent trades per day. In the end, this hurts the overall performance of the investment by taking away from the client the opportunity to reinvest those funds. The 12b-1 fee is applied to mutual funds for the purposes of distribution, marketing, and promotions. This fee is usually around .25%-1% of the fund’s net assets and accounts for $11 billion dollars a year. This commission does not provide any advantage to the fund, and is just another place your return in going. Sales commissions for front-end load mutual funds can be up to approximately 5.75%. Together, these costs can add up to 2.20% to 9.00% subtracted off of your total return in large cap and emerging market investments, respectively. The expense ratio for an index fund, which is comprised of advisory and administrative fees, may be around one fifth of a percent of your return; while it may be 1.5% for an actively managed investment. Research also suggests that there as inverse relationship between costs and returns.

Economic downturn and Active Management

Frequently, supporters of the active management strategy argue that in the time of market downturn, a repositioning of the portfolio will protect investor returns by using defensive stocks and cash. Vanguard, a US investment company, found that this statement is simply not true. The company evaluated actively managed portfolios during the six bear markets, a period of declining prices, which occurred from 1970 to 2007. The study found that only half of all active managers outperformed the benchmark. However, the study observed an interesting reality; the number of active funds that successfully outperformed the market repeatedly is minimal. Only 11% of all U.S. active managers beat the benchmark in all six bear markets. Investors should be aware that although there is small percentage of successful managers, this does not imply that there is guarantee your assets will be protected. The European market is significantly worse for it could not show a reliable managed fund that beat the benchmark consecutively for 3 periods. This indication of inconsistency demonstrates clients should not rely solely on actively managed portfolios to protect them in times of adverse conditions. On a side note, in the same study, Vanguard found that fewer actively managed funds outperformed the benchmark in a bull market, where prices are rising. This may indicate that while investors are buying defensive stocks during bear markets, those same investments do not have the same results. Stockbrokers may also be making riskier decisions in bull markets that do not put their clients at an advantage.

Taxability

Taxability is also a major issue when deciding between passive and active investing. It can be the largest factor in determining your overall return. Investors should consider tax implications when developing their investment strategy. It appears passive managed accounts produce more tax-efficient returns for the investors. The big difference between the two types of management is how often and how many trades are made. During a decline, active managers are more willing to liquidate all of the shares of certain holding if they feel returns will suffer. Morningstar studied domestic equity mutual funds in 2003 and found the average turnover exceeded 120%. Higher turnover may result in higher distributions of capital gains per period because the manager’s entire holding of that investment is realized. At a recent industry meeting, Morningstar analyst discussed the bloat ratio of funds. Morningstar also gave a formula for estimating cost of turnover.

Annual Turnover % / .60 = Estimated additional cost

Current state and federal policies have high tax rates for short term gains, which can reach up to 35%, while many investors can pay around 15% to taxes of long-term capital gains and dividends. A tax efficient index fund can also decrease your tax burden by turning losses into tax deductions. Investors can use investments that sold for less than what they paid for to offset gains realized in the same portfolio. In a recent study, Vanguard and Morningstar, Inc. calculated the total tax costs of 823 active fund and 52 index funds. It found that 75% of the index funds have lower tax costs than actively managed funds. Investors must not just look at the day to day trading prices; they must seek to use methods that maximize after-tax returns. (More details on the article “Tax-efficiency equity investing: solutions….” From Vanguard)

Warren Buffet on passive investing

At the Berkshire Hathaway 2007 annual meeting, Warren Buffet expressed his support for passive investing, saying that “A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money…The gross performance may be reasonably decent, but the fees will eat up a significant percentage of the returns,” he said. “You’ll pay lots of fees to people who do well, and lots of fees to people who do not do so well.” He even conceded that he would be “amazed” if Berkshire Hathaway’s portfolio outperforms the S&P 500 by more than few points, given its size.

Active managers may have a bad investment strategy or they might just make bad decisions with their clients’ money. Passive management aids investors achieve their financial goals with limited risks. Investors should stay away from guessing, i.e. predicting the market, and aim to control the aspect that they can, such as costs, taxes, and risks. Simply put, the most consistent method of producing a return is with index or passive management.

Berstein, William. The Four Pillars of Investing. McGraw-Hill. 2002.

Philips, Christopher B. “The Active-Passive Debate: Bear Market Performance.” The Vanguard Group. 2008.

Donaldson, Scott J. and Francis M. Kinniry Jr. “Tax-Efficiency Equity Investing: Solutions for Maximizing After-Tax Return.” 2008.