Before we get into it…let’s define both Active and Passive (index) investing strategies.
Active management utilizes the human element which would potentially include a single manager, co-managers or a group of managers actively managing a fund’s portfolio in attempts to beat market returns. Active management often includes analytical research, forecasting, and personal judgement in order to make investment decisions pertaining to which securities to buy, hold, and sell.
Passive management utilizes the use of mutual and exchange traded funds (ETF) in an attempt to mirror a market index; such at the “S&P 500” or the “Russell 2000”. Passive managers typically firmly believe in the efficient market hypothesis which conveys that at all given times, the market incorporates and reflects all relevant information that would affect the security price. As a result, this theory presents individual stock picking, or active fund managing ineffective.
Now…let’s get to the good stuff. The information immediately below is provided by Wharton University of Pennsylvania and was reinforced at Johns Hopkins Carey Business School.
Passive Investing Strengths
• Very Low Fees – Resulting from no need to analyze securities within the index
• Good Transparency – Investors are fully aware of what securities the investment possesses
• Tax Efficiency – The index fund’s buy-and-hold style does not initiate large capital gains tax
Active Investing Strengths
• Flexibility – Fund managers are not required to hold specific securities. The managers can be flexible with their holdings as long as certain criteria is met mentioned within fund prospectus.
• Hedging – Various strategies such as short sales and options can be used to counter losses
• Risk Management – Fund managers have the ability to get out of specific holdings or market sectors if risks are too great.
• Tax Management – Strategies can be implemented tailored to the individual investor for tax purposes
Warren Buffet, who is widely considered to be one of the (if not the) greatest stock pickers of all time. His track record certainly justifies his legendary reputation. However, the finance icon says that most investors’ best option to grow their money for the long term is passive investing. In fact, he even advised his own wife to invest her inheritance into index funds upon his death. Take a guess on his net worth…84.5 billion. Buffett has provided numerous letters to shareholders conveying hard evidence and reasoning that actively managed funds will under-perform when compared to amateurs who simply invest into broad index funds.
Burton G. Malkiel author of “A Random Walk Down Wall Street” is another finance icon who advocates for index investing. Throughout his highly regarded book, Burton tackles multiple investing strategies, axioms, truisms, and superstitions. The central premise backed up by rock hard data supports the notion that index funds will serve the individual investor better than active. Through arguing fundamental and technical stock analsyis as part of his framework, he points out that through technical analysis the main problem is that transaction costs and taxes make it hard to outperform a buy-and-hold strategy (index investing). In addition, Malkiel writes that technical analysis associated with actively managed funds is a way for brokers to sell stocks. As a result, the fund analysts do not help produce yachts for the customer, but they help generate trading that yields yachts for the brokers.
Finance Icon John “Jack” Bogle who is the founder of the Vanguard Group highly supports low cost index funds. Vanguard is well regarded as an institution who provides these low costs index funds, so this isn’t a surprise. However, Mr. Bogle did not start his career with low cost notion. He graduated from Princeton and went to work for and move up in Wellington Management Company. He has several basic rules for investors but in general, he conveys to select low cost funds. He has such a strong following that dedicated followers have their own designation: “bogleheads”.
As far as analysis is concerned…all individuals would need to do is google the returns of low-cost index funds in comparison to actively managed funds. However, this below chart is pretty solid. Below is a chart acquired from a Morningstar study released in June 2015. Morningstar researchers calculated the success rates by the percentage of actively managed funds that outperformed and provided better returns than the average corresponding index funds in the referenced category. If we look at the 10 Year return column, you will see that active funds that invest in value stocks of mid-sized companies were in fact the only fund category of the 12 referenced categories that had a 10-year success rate above 50 percent when compared to index-fund counterparts.
I invest into passively managed funds (index funds) for the long haul. I am not saying that there is no room for actively managed funds within ones portfolio. But what I am saying is that there is an overwhelming amount of data and testimony’s from some of the great finance legends that passive investing for the long term is more beneficial and will provide higher returns. Personally, I am a huge advocate of index investing. Some of the smartest and best finance experts have difficulty picking stocks and beating the market…so why would the average Joe trust a fund manager to do the same? In addition, why would you pay enormous fees? You cannot put a price tag on peace of mind. My long term holdings are wrapped up in index funds. As a result, I can sleep at night knowing that greedy and doomed fund managers do not have discretion when it comes to my holdings. I sleep very well at night. Very well indeed.
Don’t fall for the advertising. Don’t succumb to trends. Don’t buy into fund manager’s track records.
Invest into passively managed index funds for the long haul. Retire a wealthy individual.