FIB Educational Debate: Active vs. Passive Investing

Passive Patrick vs. Active Amy

Active Amy (AA): Hey Patrick, do you have any recommendations for good mutual funds for long-term retirement investing?

Passive Patrick (PP): Andy, why choose a actively-managed mutual fund, when they will charge you at least a one to two percent flat fee just to manage your money, regardless of their performance?   You should use low-cost index funds, which you can manage yourself for a fraction of the cost.  Many ETFs and index funds have fees that are only a fraction of one percent!  Those cost savings add up over the years.

AA: Patrick, I know passive investing is “all the rage” right now, but with the market at high valuations, and economic uncertainty ahead, it is worth the extra cost to find a manager that can find strong and healthy businesses that can also has a chance at outperforming the market.  There are still some active managers out there that can get me some “alpha”.

PP: But Patrick, research has shown that 10 percent or less of mutual fund managers have actually outperformed the U.S. stock market, and those numbers don’t even account for the all the funds that have closed.  Not to mention, many of the most successful active funds are closed to new investors, as their success has brought them so much funding that the managers are hesitant to take on new clients for fear of it diminishing their ability to continue outperforming.

AA: Patrick, active managers have certainly had a tougher go of it lately, relative to the overall market, but I believe this is primarily because we’re in the longest economic recovery and bull market in history, with the stock market growing at higher than historical averages.  I concede that it’s difficult for any managers to get consistent market-beating returns when the market returns over 10% annually in a strong bull market, but these great times won’t last forever.  Active management is far from dead, and if the stock market reverts to lower returns, say 6% or less annually, active management will be able to add significant value by researching into specific companies or sectors that can outperform.

PP: But what about the efficient market hypothesis (EMH), which shows us that markets are efficient almost all of the time, especially these days when information flows around so freely through media and digital channels?  Active managers don’t have any special information that the rest of us can’t access, so how can anyone expect to beat the market consistently when almost all information is already reflected in the current price?

AA: EMH has some value, but people misinterpret EMH as saying markets are always efficient, when it only says that they are efficient most of the time.  That’s a huge distinction, Pat.  While almost all information is indeed reflected in the current stock price, humans have a tendency to overreact to bad news and underreact to good news (or vice versa), causing the occasional mispricing of a company. Also, how could markets be efficient when they swing so widely based on investor psychology?  If markets are efficient, how did Warren Buffett, an active manager I might add, become a billionaire?!

PP: Okay Amy, I acknowledge that the stock market isn’t perfectly efficient, but let’s be honest: you ain’t no Warren Buffett, and neither is your mutual fund manager!  The Buffetts of the world are few and far between, and most individual investors are better off just sinking their money into a S&P 500 index fund.  Also, even Warren Buffett has acknowledged that index funds are the smart approach for most investors.  Additionally, his partner Charlie Munger even admitted that it would be difficult today to accomplish what he and Warren using the same strategy.

AA: Patty, the point I want to make is that active managers with discipline and a systematic approach can indeed beat the market by a few percentage points each year, which, compounded over time, can have a HUGE difference in your wealth-building.  For example, back-tested research has shown that both value strategies and momentum strategies have outperformed the market over several decades, even with returns in the 18-20 percent range annually!  These aren’t monkeys throwing darts either.  These are systematic strategies that screen stocks for certain characteristics and rebalance regularly.

PP: But Amy, how many managers, let alone individuals, can realistically consistently employ that type of a value or momentum strategy over multiple decades?  Not only does it require incredible discipline, but value and momentum strategies can also experience SERIOUS periods of underperformance, and take it on the nose during market downturns.  That’s why so many managers have turned to growth strategies in the last decade, because value strategies have underperformed for nearly 10 years!

AA: Patrick, I’m not saying value and momentum will always outperform, just simply that there are strategies – including quantitative ones – that can beat the market.  And that’s precisely the job of an active manager: to find the strategy or strategies that will provide those market-beating returns over a period.  Growth has indeed outperformed value as of late, hence why a smart active manager would have stuck with a growth strategy for last 10 years.

PP: I take your point on the possibility that one can beat the market, but I’m skeptical an active manager doing well over the last 10 years would be able to match that same performance over the next 10.  Their performance can shift with the tides just like the market.  I’m just not willing to risk 1-2% of my investments on someone else’s abilities.  I see why an active approach is appealing, but I recommend you keep a close eye on any manager’s fees, as well as his or her past performance.  If you sense that you’re having a hard time finding a reliable manager, you can always keep your portfolio in index funds until you feel more comfortable.

AA: Thanks, Patrick.  I will indeed make sure any active manager I choose has a strong track record and reasonable fees (preferably closer to 1%).  I’d also recommend to you, Patrick, that you consider putting a portion of your assets with an active manager, or that you keep a small portion on the side for some concentrated bets on good companies.  Keeping even a modest portion of your funding with an active manager or your own researched picks could help diversify your portfolio and increase your returns.  Investing in individual companies at an attractive price – especially large companies with strong balance sheets and brand name recognition – is not as risky as people believe.

Key Terms

  • Alpha: Returns gained in excess of the overall market’s returns, normally compared to particular index, such as the S&P 500. Example: If the S&P 500 gained 10 percent in a year, and an active manager’s large cap fund gained 12 percent, then that fund manager would have contributed 2% of alpha that year.
  • Growth Investing: Class of investment strategies focused on finding companies whose earnings are expected to grow in the future, which will increase the value and market capitalization of the company and provide returns to investors. Companies that are classified as “growth” often trade at higher valuation multiples, e.g. a higher price for every dollar of earnings, because of the expectation of future earnings growth.
  • Value Investing: A category of investment strategies that seeks to find companies that are trading below their intrinsic value. Value strategies generally look for stocks trading at lower valuation multiples, using ratios such as price/book value, price/earnings, or price/sales, for example.  [Note: There is no single value strategy. The term value investing is used rather liberally to describe a broad group of investing approaches that focus on finding companies at a bargain based on the fundamentals of the company.]
  • Momentum Investing: Momentum investment strategies focus on the recent price movement of stocks, rather than the fundamental value or earnings growth, and seek to purchase stocks with positive momentum to take advantage of additional expected gains. A generic momentum strategy would purchase stocks with the greatest appreciation in a certain period of time, such as the preceding 3 months, 6 months, or 12 months.  Momentum investors are seeking to take advantage of the fact that stocks with recent price appreciation are likely to have continued success in the short-term.  [Note: Momentum and growth investing are NOT the same.  Growth strategies emphasize companies’ earnings, while momentum strategies focus on the stock price appreciation in recent months.]
  • Efficient Market Hypothesis (EMH): Posits that asset prices reflect all available information, suggesting that the stock market efficiently prices in available information to the company’s market capitalization and stock price. EMH implies that is it impossible to outperform the market without taking on additional risk, because of the positive relationship between with risk and returns.  EMH is often attributed to research by Paul Samuelson and Eugene Fama, although the idea of efficient markets can be traced to variety of different sources.