The debate around active versus passive investing has been going on since the first index fund was introduced in 1975. And I have to admit, that for the majority of my financial career, I’ve never had an opinion one way or the other. That is—until I set about building my own Registered Investment Advisor (RIA) firm in 2016. Finally, after almost 20 years in the business, here is what I think and why.
Passive investors (those who favor index funds) tend to believe that markets are efficient and that all available information about a company is reflected in its current stock price. So, rather than trying to beat or second-guess the market, passive investors simply buy the entire market (or a specific segment of it) via index funds.
Active investors counter that the market is not always efficient and are therefore willing are to pay higher investment fees to active fund managers in order to pursue strategies that attempt to time the market, or overweight/underweight individual securities or market segments.
While in some situations, active funds have proven advantageous, the following two facts have me to believe that, particularly over the long-term, passive strategies are a better investment strategy. First, the majority of active funds do not consistently beat their passive counterparts. According to an article in Forbes, over a recent 15-year period (2001-2016), the S&P 500 (commonly available as an index fund) outperformed more than 92% of active, large-cap funds trying to beat it. Mid- and small-cap fund benchmarks bested their more active challengers 95.4% and 93.2% respectively during the same period.
Second, is the issue of cost. In 2016, the average expense ratio of an actively-managed equity mutual fund was 0.82 percent, while index equity mutual fund expense ratios averaged 0.09 percent. If you invested $10,000 annually over 30 years in your 401(k), the higher of these two fund expense ratios (0.89%) would leave you with $117,938 less in your balance.
Markets may not always behave rationally. Investments can become over-valued (think tech stocks in 1999, or real-estate in 2006), or under-valued (think stock prices in March 2009). But on average, investment prices tend to accurately reflect their true value. Therefore, I favor client portfolios that contain investment vehicles that are well diversified, tax-efficient, and low-cost. While there may be instances where it makes sense to integrate an active fund or individual securities into your overall portfolio, I believe most investors in pursuit of long-term goals (like retirement) are best served by spending their time and energy on identifying the proper asset allocation, and investing the majority of their assets through a low-cost, passive (index) approach.
(1) Buckhari, Jeff “Stock-Picking Fund Managers Are Even Worse Than We Thought At Beating the Market” April 2017
(2) “Trends in the Expenses and Fees of Funds, 2016” ICI Research, May 2017, Vol. 23, No. 3