Active or Passive Investing: deciding which is best for you

Some might think active investing is what happens if you called your sharebroker between golf games and board meetings. Conversely, passive investing could incorrectly conjure images of sitting on your couch and shrugging a lot at your investment choices. Neither are accurate.

Active and passive investing are in fact two distinct investing strategies, neither of which require the investor to do much of anything at all after choosing one.

The great majority of managed funds are actively managed, meaning they employ a fund manager to be their guru; like the captain of a ship or the CEO of a corporation. Before launching a fund, the fund manager will lay out their supposed skills, qualifications and general strategy for choosing the investments in the fund in offer documents (in particular the SIPO).

The fund manager will then have a free hand to buy and sell securities for that fund in the hopes of outperforming its benchmark. The managed fund will grow and shrink according to how much is invested, but its holdings will remain whatever the fund manager chooses. These buying and selling choices is what makes this kind of investment active. You might say active investing involves a lot of tinkering, it’s all about trying to pick investments that may outperform their peers and the market.

Actively managed funds buy and sell individual stocks regularly with the aim to beat the return of a given market. A passively managed fund, on the other hand, invests to match a specific index, for instance the S&P/NZX 20, rather than picking stocks based on the fund manager’s choice.

Active investing involves trusting your money to a fund manager who uses their investment skills to try and beat the market return. This gives you the chance to beat the market return if your fund manager gets their market timing and stock selection right.

Every active manager in the world thinks they can beat the market – that’s why they’re in business. But not everyone can win. Because they have lots of costs associated with research and trading, the large majority of active managers lose.

What’s more, over the past few decades, active investing has become harder and harder. It’s not because active fund managers are getting less skilful, but ironically because funds management is extremely competitive. As more fund managers have joined the industry, it gets more difficult for them to beat the market because active managers are the market.

Investing is a ‘zero sum game’; in the long term fund managers in aggregate can only earn the market return minus their fees. Since they tend to charge relatively high fees, active fund managers very often do worse than the market after fees are taken out!

There’s little, if any, tinkering with an index investing strategy. An index investor would, for example, seek to track the performance of the entire stock market and mirror it. They could do this by investing in a single index fund — a single investment that allows you to invest in multiple companies (or bonds and real estate, too). They could decide to invest in the Kernel S&P Global 100, a fund that tracks 100 mega-national companies.

Or they might decide to invest in the comparatively smaller companies that make up the Kernel NZ Small & Mid-Cap Opportunities Fund, each being worth $100million+.

Generally, index investors believe that regardless of how much their investments rise and fall in the short run, they’ll grow over time. This is based on the concept of efficient markets; that there are no bad companies, just companies that investors don’t believe in as much and are therefore willing to buy for less at any point in time.

An active strategy operates on the idea that smart humans will be able to outsmart the markets — and indeed some have done so brilliantly.

The most famous fund manager of all time might be Peter Lynch. The silver-haired stock savant managed a Fidelity fund between 1977 and 1990, a period during which he averaged a staggering 29.2% return for investors.

Most other fund managers have not been as lucky and failed to outperform the market. The biggest challenge with this is persistence. Just like a coin toss, the chances that an above average manager remains an above manager in a subsequent period are no better than 50%. In fact research indicates the results are worse.

Index investors, on the other hand, are betting that over the long term, they will benefit from both the long established upward trajectory of markets (along with the fact that index fund fees are but a fraction of their active brethren).

Active management fees are typically more than 1%, whereas index fund fees are normally below 0.50%. Index funds like to point out the data shared by academics and Vanguard’s founder Jack Bogle showing that fees are inversely predictive of returns. That is, the higher the fees, the lower the returns.

Warren Buffett, who became one of the richest men in the world by picking specific companies and stocks to invest in, has spent decades discouraging pretty much everyone not named Warren Buffet from trying to make money through active investing.

He is more aware than many of active investing pitfalls, especially if you can’t buy large portions of a company to sit at the board table and influence strategy.

Buffet favours index investing and has long publicly encouraged his heirs to invest the lion’s share of their inheritance index funds when he dies. “My advice to the trustee couldn’t be more simple: put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.”

Let’s get one thing straight. Investing through index funds is a far superior strategy to picking individual stocks because you’re engaging in something called diversification. Everybody has a friend whose uncle knows a guy who invested $500 in Amazon in 1997 and now owns his own continent.

Less heralded, but more prevalent, are the tales of other guys who sold Amazon after a dip or who went all in on Groupon and had to move back into their parents’ garage! Picking stocks for a short period is only a marginally better idea than investing in lottery tickets.

Many investors understand that one way to help protect against unexpected large losses in specific stocks, economic sectors or economies is through diversification. When you diversify your investments, if one goes sour it doesn’t drag down your entire portfolio.

The advantage of active investing is that sometimes, you might do really, really well. Had you owned the small cap Perkins Discovery Fund in 2017, you would have enjoyed a 39.51% percent return on your investment. If you’d been invested passively in one of the S&P 500 funds during the same period, you’d only have experienced returns of 18.5%.

But this creates a somewhat deceptive picture. Over a 10-year period from November 2008 to November 2018, the index actually outperformed the actively managed fund by more than 6%.

This reflects a truism that index investment devotees never tire of pointing out. While many active funds outperform index funds in the short term, they will fail to outperform them in the long term (10 years +).

Studies have shown that over 90% of actively managed funds fail to outperform index investments over the long term. Especially when it comes to the actual growth of an investor’s investment. That’s the important part isn’t it?

Active managers could argue that between 2008 and 2018, overall stock market returns were so fantastic it’s not all that surprising the market would outperform any given fund. It’s in bear markets when active managers will really earn their keep, by timing the market and shifting to cash in order to preserve more of your investment.

But at least one full study and examples to date in 2020 showed that this is but another investing myth. Thanks to the increased attention in index investing and the poor performance of supposed experts through the Global Financial Crisis, there’s been a seismic shift of money moving into index funds.

Along with this shift has emerged a small but vocal contingent of financial minds arguing that this massive outflow from active has created potential dangers to the market. Google “passive bubble” to see the misinformation and self-interested propaganda.

The truth is, nobody can ever really predict what the future holds in the market. Investments are speculative and past results should never be understood to be guarantees, but instead imperfect predictors of future performance.

Whichever way you choose to go — active, index, or a combination of the two — you have the option to either invest it alone or with some help. Whatever investing strategy you decide on, try not to make changes along the way that are driven by your emotions.

There’s probably never been a worse investing strategy than trying to time the markets according to when you imagine stock prices are rising or falling.