Passive Investment Management versus Active Investment Management
I love a good debate. In the investment world there is an ongoing debate over active management versus passive management. Is it a debate worth debating?
The debate refers to a style of investment management.
The gist of the debate is whether an active manager can outperform a passive manager over time. Outperformance means the return on your investment.
Generally speaking, mutual funds are actively managed and exchange traded funds are passively managed.
I am going to tell you up front that technically I do not believe passive management exists.
That’s kind of the end of the debate for me. But for you?
As an investor you are asked to make decisions. Decisions about what fund(s) to invest in.
What criteria should you use when making an investment decision? Is active versus passive something you should care about?
Well, someone might recommend a “passively managed” fund as “less risky.”
“Less risky than what?” you might (should) ask.
Passive management is associated with index funds. The example I will continue to use is an index fund that seeks to replicate the performance of the S & P 500.
An index represents a specific group of stocks or bonds. For example, the S&P 500 is a widely used stock market index.
Indices are not “actively” managed. The stocks included in the S&P 500 are based on the size of a company. The size is called the total market capitalization or in street speak “market cap.”
It is very formulaic and there is no investment committee deciding daily what stock should or shouldn’t be in the index.
Microsoft is the largest company in the index. The total market capitalization of Microsoft is $820 billion. Microsoft is 3.57% of the index.
The smallest company is Goodyear Tire and Rubber Company. Their market cap is $4.2 billion. The weighting of Goodyear in the index is 0.02%.
One of the theories behind passive management is that it doesn’t require much skill on the part of the manager to track an index. Just buy and weight the same 500 stocks in the index and you are all set.
Kind of like going on auto pilot. If you are on auto pilot, the costs of managing an index fund should be lower than an actively managed fund , so the theory goes.
I have done a lot of flying and to the best of my knowledge, the pilot decides if the plane is going on auto pilot. There is always someone who decides.
If a pilot decides to use auto-pilot, does the pilot get paid less? Does the pilot leave the cockpit?
If you see the pilot walking up and down the aisle chatting it up with the passengers, don’t you ask, who’s flying the plane?
An actively managed fund means there are people deciding what stocks to include in a portfolio. Active managers are NOT replicating an index. Active managers believe that making active decisions, what stocks to buy or sell will lead to better performance than a passively managed fund, over time.
In every fund there are many moving parts.
If I am a passive manager replicating the S & P 500 index there are scenarios that will impact the performance of my fund that I have no control over.
There are cash flows. Big cash outflows may require selling some of the stocks in the portfolio. As a manager I may be forced to sell stocks at a lower price than my cost, incurring losses.
If there is a big cash inflow and I need to invest, I will have to buy stock at the current market price to replicate the weightings of the index. I can’t wait around for a better price if the current market price is higher than I think the stock is worth.
Cash flows are not symmetric so a passive manager may have to rebalance the portfolio constantly to stay in line with an index.
Rebalancing forces the activity of buying and selling “at the market”. Buying and selling is an activity. Something active is happening.
Note the word activity.
The activity of buying and selling stock to replicate an index, may incur gains or losses.
Cash flows, gains and losses all impact the performance of the fund.
What you want is the best possible performance over time. No brainer on that point.
What you do is compare funds by performance measures.
You are going to compare the after-fee performance of one fund to another fund(s) regardless of active or passive management.
Here is a hypothetical one-year return scenario, the investment risk is the same for each fund:
| S&P 500 Index (no fees) | Return: | 10.00% |
| Passive Fund (fees 25 basis points) | Return Before Fees: | 10.00% |
| Return After Fees: | 9.75% | |
| Active Fund (fees 100 basis points) | Return Before Fees: | 11.25% |
| Return After Fees: | 10.25% |
In this scenario the passive manager has lower fees. The return is right on target with the S&P 500 at 10.00%. After fees the return is 9.75%.
The active manager has higher fees. The return is higher than the S&P 500. After fees the return is 10.25%.
In this case your investment returns would be better with the active manager even though the fees are higher.
In the real world the opposite is also true. Lower fees AND higher performance are the optimal scenario.
The point in showing you this scenario is to make sure you are focusing on comparing after fee performance.
Lower fees alone do not guarantee higher returns.
If you are comparing an actively managed fund (typically a mutual fund), to a passively managed fund (an index fund) there are three things to consider:
- Passive does not mean less risk.
- Passive does not mean lower fees
- Passive does not mean that the portfolio is on auto pilot.
Those “in the know” will drown you in data to prove that passive management outperforms active management over time. That is debatable.
What matters is performance. Go with the best after fee performance.
This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.
