Active vs passive investing

In my article on why I believe stock picking is really hard I highlighted some of the factors that work against the retail investor when they partake in active investing i.e. picking stocks. Continuing along the same lines as that post I wanted to discuss active and passive investing in more detail as well as give my opinions on where I sit on the debate. 

Active investing

The idea of active investing centers around choosing individual assets in an attempt to beat a particular benchmark, typically something like the S&P 500 or ASX 300. Although strategies vary greatly between investment managers, what they do have in common is that they will follow some sort of methodology to try to beat their chosen benchmark; this can mean that they try to choose assets that will outperform in the long run and/or time price movements.

In general, active investors believe that the market is inefficient, in other words, it does not compile all available information into the stock price. By taking advantage of these inefficiencies they aim to produce a risk adjusted return that is superior to that of the benchmark.

For the individual investor, if you are choosing your own stocks/assets based on information that you have gathered, then you are considered to be an active investor.

Advantages

• An active investor has the potential to outperform a passively managed fund, this can be achieved through timing price movements or taking advantage of information that has not been priced into the market.
• In the case where an investor has sufficient resources, they can fully customize their portfolio to suit their risk profile. For example, if you think that a particular stock in ASX200 will fall, then you can take a short position and make a profit
• Active managers can have much greater flexibility when it comes to purchase/sale of assets, they can potentially buy assets that are not covered by analysts due to factors such as size or liquidity.
• If you choose to do it yourself then the cost can be lower than a passively managed fund, depending on how your value your time.

Disadvantages

• If you go with a fund the fees are significantly higher than a passively managed fund in order to compensate the investment manager for their additional effort required to choose asset positions. This means that the MER’s are higher (often they are over 1%) and you may be subject to a performance-based fees
• Some funds will put restrictions on when members can enter or leave the fund. This can reduce fund member liquidity or leave them in a situation where they have excess cash.
• Performing, research, portfolio management and other active management tasks is time consuming

Passive investing

Passive investing involves purchasing a product that replicates the returns of a benchmark like S&P 500 or ASX 300 and accepting the returns that come with it. There are many companies that offer passively managed products and they can come in the form of managed funds or ETF’s.

Passive investors acknowledge market efficiency, which means they believe that all of the available information is compiled into the share price. They also accept the relationship between risk and return, which implies that no additional return can be gained without taking on necessary risk.

Advantages

• Passive index funds typically have lower fees than actively managed funds since there is less cost involved in building the fund
• Index funds are highly diversified and will tend to remove much of the idiosyncratic risk associated with owning a concentrated portfolio of shares
• It takes very little time and effort to construct a portfolio of passively managed investments

Disadvantages

• An index fund investor must accept the index’s constituents, regardless of how they think that certain companies that make up the fund will perform in the future
• Passive investors must accept the relationship between risk and return which means that there is no possibility of achieving excess risk adjusted returns

What does the evidence say?

Most active managers under-perform
The majority of active fund managers do not beat their benchmark indices after fees. This is true over 3, 5, 10 and 15-year periods up to June 30, 2018 (S&P Dow Jones Indices, 2018). For example, for the 10-year period to June 30, 2018, 85.93% of all US Domestic Funds failed to outperform the S&P Composite 1500 index. (S&P Dow Jones Indices, 2018). I’ve provided a screenshot from the SPIVA US mid year 2018 report below:

Over the course of 2019, in Australia, only one quarter of active large cap managers covered by Morningstar beat the index after fees (Rapaport 2020).

Some managers outperform
There are numerous investment managers that have significantly outperformed the indices over a sustained period of time. Warren Buffett and Peter Lynch are 2 examples; Warren Buffett’s Berkshire Hathaway has posted an average annual return of 17.1% p.a. since 1985 (Franck 2019). Peter Lynch’s Magellan Fund returned an average of 29% p.a. between 1977 and 1990 (Chen 2019). In more recent times approximately one third of Australian active managers did not underperform the index during the first quarter of 2020 (Morningstar 2020). This implies that they’ve been able to partially shield their investors from the downside risk of the most recent bear market.

There is also conjecture around the SPIVA research by S&P present above, notably that it is US centric. Some evidence suggests that active management is better suited to emerging markets. In the 3 years prior to March 3, 2020 active managers of $100m or more outperformed their passive peers by 2.3% (Maki 2020). In addition to this, from 2013 through to March 2017 over 60% of active managers have outperformed the index over rolling 5-year periods in the UK (Ralston 2017).

What’s my opinion on this?

The data on passive out-performance in the past is fairly robust and comprehensive. Combining this information with my own personal experience leads me to believe that the market is very efficient compounding information into asset prices. Further to this, the advancement of technology and computing power will drive increases in market efficiency going forward. Having said that, I do not believe that it is perfectly efficient, there are still pricing inefficiencies that exist, however only the very best/luckiest investors are able to take advantage of them.

Personal experience
In my 20s I tried picking my own stocks and in short, my money would have done better if I had just purchased a product that tracked ASX 300. I simply wasn’t effective enough at applying stock valuation techniques to be able to take advantage of the publicly available information. In addition to this, I fell victim to cognitive and emotional biases that caused me make irrational decisions and decrease my returns. Do I regret not choosing passive investing earlier? Absolutely not, after all, a big part of life is giving things a go and reflecting on experience. Direct investment in shares taught me a huge amount about markets, companies, financial statements and investing behavior. This base of practical experience also helped me to understand the theoretical concepts of finance that I studied whilst at uni.

Balancing active and passive management styles
If you subscribe to an evidence-based methodology and choose to purchase an index type investment, in the long run, it’s likely that you will outperform the majority of active fund managers after fees. Let me reiterate that these fund managers are teams of professionals whose full-time job is to generate returns for the fund members – it is not unreasonable to assume that their skills, knowledge and resources will be greater than the average retail investor.

Based on my personal experience, I still believe that stock picking can have a place in your portfolio. As I’ve said earlier, it’s a great way to learn about finance, markets and companies. There is also a very small chance that you could outperform the benchmark and make huge returns. So, for these reasons I believe that it’s not unreasonable to set aside a small portion of your portfolio to do your own active management. The amount is going to be different for everyone but I would suggest setting aside a proportion of your portfolio such that if that money is lost it will have little to no effect on you achieving your financial goals.

Concluding thoughts

The fact that most professional fund managers have been unable to beat their own benchmarks in the past speaks volumes. I also have no reason to believe that this will change in the future. My personal belief is that the data speaks for itself, which implies that the most rational choice for retail investors to maximize their returns lies in a passive approach. In addition to this, finding an active manager that will outperform the market in the future is a very difficult task in itself. For example, if find an active manager that has outperformed the market over the past X years, what guarantees that they will continue to do so in the future? How can you know if the out-performance a matter of repeatable skill or luck?

As humans we are conditioned to believe that by exerting more effort and having more control tends to yield better results. While this is true for many things, I’ve found little correlation between effort and returns when it comes to investments. However, because it is so difficult to escape our ingrained tendencies one way around this is to invest the majority of your portfolio into passive index investments and use the reminder in a more active manner.

Engineer your freedom

References
Rapaport, E. 2020, Moment of truth for active funds, Morningstar, viewed 18/7/2020, <https://www.morningstar.com.au/funds/article/moment-of-truth-for-active-funds/201895>

Frank, T. 2019, Warren Buffett has kept the same investing philosophy for decades, early interview shows, CNBC viewed 18/7/2020, < https://www.cnbc.com/2019/09/22/warren-buffetts-investing-advice-consistent-over-past-35-years.html>

Chen, J. 2019, Peter Lynch, Investopedia, viewed 18/7/2020, <https://www.investopedia.com/terms/p/peterlynch.asp>

Maki, S. 2020, There’s still a way to gain an edge with actively managed funds, Financial Planning, viewed 19/7/2020, < https://www.financial-planning.com/articles/heres-why-active-management-still-has-an-edge-over-passive-investing>

Ralston, G. The case for active asset management, Morningstar, viewed 19/7/2020, <https://www.morningstar.com.au/funds/article/the-case-for-active-asset-management/9002>

Soe, A. Berlinada, L. (2018) SPIVA U.S. Scorecard, available at: <https://us.spindices.com/documents/spiva/spiva-us-mid-year-2018.pdf?force_download=true> Accessed (19/7/2020)