ON THE MONEY: Active or passive investing

November 18, 2018

Early in his career on Wall Street, John Bogle was a strong proponent of active investment management and such proponents of this approach believe that a great investment manager will be able to generate returns that outperform a benchmark index, such as the Standard & Poor’s 500 Index (S&P 500.)

However, over the 23 years ending in 2009, actively managed funds trailed their benchmarks by an average of one percentage point a year. If the Standard & Poor’s 500 returned 10 percent, the average managed fund investing in similar stocks would therefore have returned 9 percent, while an index fund would have returned 9.8 percent to 9.9 percent, giving up only a small amount for fees.

A 2016 study by S&P Dow Jones Indices showed that about 90 percent of active stock managers failed to beat their index targets over the previous one-year, five-year and 10-year periods; fees explain a significant part of that under performance.

However, U.S. stock-pickers’ success rate increased sharply in 2017, as 43 percent of active managers categorized in one of the nine segments of the Morningstar Style Box both survived and outperformed their average passive peer. In 2016, just 26 percent of active managers achieved this feat.

In 1976, John Bogle, the head of the Vanguard Group, launched the first index fund, known as the Vanguard 500 Index Stock Fund, and this fund was the harbinger of things to come, since index funds now have well over $3 trillion of assets.

Bogle gives a lot of the credit for the launch of this fund to his old mentor, Paul Samuelson, who won the Nobel Prize in Economic Studies in 1970 and encouraged Bogle to take on the investment establishment and introduce his indexed fund.

In active investment management, the manager attempts to outperform the overall market, utilizing techniques such as buying undervalued stocks, engaging in short sales, anticipating market trends and managing risk. Using this approach successfully over the long haul has become increasingly more difficult due to the rise of sophisticated stock trading programs.

“Before the era of computer-dominated trading, it was slightly easier to identify winning advisers in advance, because you could more easily understand and evaluate what they were doing,” says Lawrence G. Tint, chairman of Quantal International, a risk-management firm for institutional investors, and former U.S. CEO of Barclays Global Investor.

Bogle and other advocates of unmanaged, passive investing have long held that the best way to capture overall market returns is to use low-cost market-tracking index investments. This approach is based on the concept of the efficient market, which holds the market is perfectly aware of future changes in the economy and continually makes its own adjustments to new information as soon as it become available. As a result, market prices adjust in response to reflect a security’s true value. That market efficiency, proponents say, means that reducing investment costs is the key to improving net returns.

Active management does provide one important advantage to investors, particularly, those with large investment portfolios, and that is the ability to manage the portfolio in a tax-efficient manner. For example, a separately managed account can harvest capital losses to offset any capital gains realized by its owner, or time a sale to minimize any capital gains.

An actively managed mutual fund can do the same on behalf of its collective shareholders, but if capital gains are generated during the year, all shareholders are required to report those gains, even if the fund lost value. Then too, an actively managed mutual fund’s investment objective will put some limits on its manager’s flexibility; for example, a fund may be required to maintain a certain percentage of its assets in a specific type of security.

Indexing, on the other hand does create certain cost efficiencies. Because the composition of an index perfectly replicates the underlying index, no research is required for securities selection. Also, because trading is largely nonexistent, trading costs are markedly lower; infrequent trading typically generates fewer capital gains distributions, which translates into another form of tax efficiency.

Which is better-active or passive investing? You pay your money and take your choice. Personally, I am a passive advocate, but active is more exciting and interesting than passive investment. When one invests in an actively managed fund there is a chance of big returns, and as people are basically optimistic, they expect that they will get the big return and that others will get the lower return.

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