Last Week’s Question of the Week: How many adults “over the age of 65” are currently licensed to drive in the United States?
ANSWER: There are 42 million drivers over the age of 65!
HOST: Today your topic revolves around the differences we hear when it comes to how investment portfolios are managed. You are going to explain the terminology behind this and tell us perhaps which is better?
KLAAS FINANCIAL: We love this topic. Today we are discussing two different types of money management techniques: Active Portfolio Management vs. Passive management.
Jack Bogle, the founder of Vanguard — who passed away this past January at the age of 89 — started the debate of active versus passive investing when he created the first index fund in 1975. Today we have hundreds of index funds, and passive investing has become a household concept and is generally accepted as the preferred method of investing for millions of investors. Before we begin discussing the differences, let’s point out an interesting FACT:
Over 90% of active stock managers fail to beat their benchmarks (CNBC: Active fund managers trail the S&P 500 for the ninth year in a row in triumph for indexing).
Using a sports analogy will help us understand the key differences in the philosophies: active investing is like picking and betting on who will win the Super Bowl, while passive investing is more like owning the entire NFL, collecting profits and sometimes realizing losses on the gross ticket and merchandise sales, regardless of which team wins each year.
Active investing means that either a mutual fund manager or another investment advisor is going to use an investment approach that typically utilizes fundamental analysis, micro, and macroeconomic analysis and/or technical analysis, because you think picking investments in this way can deliver a better outcome than owning the market (or the whole team) in its entirety.
Back to the NFL analogy, you would study all the players and coaches, go to preseason training, and based on your research make an educated bet as to which teams would be on top for the year. Would you be willing to bet your money on your ability to choose correctly? An active investor or active strategy is doing just that.
Important to remember that the goal of an active manager is to “beat the market,” or outperform certain standard benchmarks. For example, if you’re an active investor, your goal may be to achieve better returns than the S&P 500 or another index. An actively managed investment fund has an individual portfolio manager, co-managers, or a team of managers actively making investment decisions for the fund. The success of an actively managed fund depends on combining in-depth research, market forecasting, and the experience and expertise of the portfolio manager or management team.
Portfolio managers engaged in active investing pay close attention to market trends, shifts in the economy, changes to the political landscape, and factors that may affect specific companies. This data is used to time the purchase or sale of investments in an effort to take advantage of irregularities. Active managers claim that these processes will boost the potential for returns higher than those achieved by simply mimicking the stocks or other securities listed on a particular index.
Since the objective of a portfolio manager in an actively managed fund is to beat the market, he or she must take on additional market risk to obtain the returns necessary to achieve this end.
HOST: What does it mean to be a passive investor?
KLAAS FINANCIAL: With a passive investment approach, you would buy index funds and own the entire spectrum of available stocks and bonds. Revisiting to the football analogy, the passive approach is like owning the entire NFL. You know that not every team is going to win, but you don’t really care because you know some merchandise, tickets sales etc. is bound to be sold each year. With a passive investing approach, you simply want to capture the returns of an entire market.
Passive management is sometimes called index fund management, because it involves the creation of a portfolio intended to track the returns of a particular market index or benchmark as closely as possible. Managers select stocks and other securities listed on an index and apply the same weighting. The purpose of passive portfolio management is to generate a return that is the same as the chosen index instead of outperforming it.
A passive investor wants to own all the stocks, because they think as a whole, over long periods, capitalism works, and they are likely to receive higher returns from investing in the entire stock market than by trying to pick which individual stocks which will outperform the market as a whole.
The point of passive market approaches is to take advantage of something called the equity risk premium which says you should be compensated for taking on equity risk with higher returns. Indexing eliminates this, as there is no risk of human error in terms of stock selection.
Passive Investing tends to be more tax efficient: Since not a lot of trading is done with passive funds, they generally have lower expense ratios. They also have less capital gain distributions that will flow through to your tax return. If you invest using non-retirement accounts, this means a passive investment approach used consistently should reduce your ongoing tax bill.
FACT: As of the end of April 2019, passive funds have just about reached parity with actively managed funds in the U.S. stock market. According to a recent Morningstar report: Investors have invested $4.305 trillion into passive US stock market funds as of April 30, only $6 billion shy of the $4.311 trillion overseen by active US equity funds. By the end of June, the data will very likely show that the passive funds have surpassed those that are actively managed. In terms of actual numbers, more than $39 billion of cash went into passive U.S. equity funds in April, compared with $22 billion for their active counterparts.
HOST: Which would you say is better for our listeners, ACTIVE or PASSIVE investing?
KLAAS FINANCIAL: As with most financial strategy choices, it really comes down to personal priorities, timelines and goals. In some circumstances the most favorable results may come from a combination of both active and passive strategies.
If your top priority as an investor is to reduce your fees and trading costs, period, an all-passive portfolio might make sense for you. In our experience, investors tend to care more about factors like risk, return and liquidity than they do fees, so we believe that a mixed approach may sometimes be beneficial for all investors—conservative and aggressive alike.
Active management may help investors improve their risk-adjusted returns. We’ve found that active managers can be especially helpful during periods of market stress, when outperformance can be most critical for investors.
Active strategies have tended to benefit investors more in certain investing climates, and passive strategies have tended to outperform in others. Generally, when the market is volatile, active managers may outperform more often than when it is not.
When specific securities within the market are highly correlated or moving in unison, passive strategies may be the better way to go.
Investors may be able to benefit from mixing both passive and active strategies—the best of both worlds, if you will—in a way that leverages the most valuable attributes of each. Market conditions change all the time, so it often takes an informed eye to decide when and how much to skew toward passive as opposed to active investments.
If you want to combine active and passive approaches you may look at putting actively managed funds inside tax-sheltered accounts like IRAs while using a passive approach or a tax-managed fund for non-retirement accounts.
To important things to remember:
- Very few people can make money as an active investor and, for those who can, a small percentage will beat the market over time.
- Don’t look at investing as a way to make money fast. The most successful investors are those who invest for the long term and understand that gains compounded over time with reasonable risk are the best way to build wealth.
Catch C.J. Klaas and Maleeah Cuevas on Money in Motion every Thursday on Madison's 1310 WIBA from 8:05-8:35am.