Active Vs. Passive: The Case For And Against Index Funds

Passive investing. It sounds worse than boring. "Passive" sounds uninterested and maybe a bit lazy—two adjectives that are hardly desirable in an investing approach.

But passive investing powers what’s possibly the most vibrant and dynamic area of the financial world: ETFs.

So what is a passive investment? At its simplest, it’s an investment that removes human hunches from the process of deciding what to own and when to own it.

In an “active” mutual fund, investors pool their money and give it to a manager who picks investments based on his or her research, intuition and experience. In a “passive” fund, there’s a rulebook that defines an index, and that index determines what’s in the fund.

Most, but not all, ETFs are passive. Similarly, mutual funds are often associated with active management, but passive mutual funds exist too.

So what does it mean to be in a passive investment? In short, passive investing means owning the market, rather than trying to beat the market.

How Exactly Would You “Own The Market”?

Owning the market simply means owning a little piece of everything, in proportion to its size. A tracker fund that matches the MSCI World Index is a great example. The fund doesn’t try to pick which stock will perform well. Instead, it invests in all of the stocks, and takes larger stakes in the larger companies and smaller positions in smaller firms.

Why wouldn’t you want to beat the market rather than match it? Traditional passive investors believe that beating the market on a consistent basis isn’t possible or, at best, is highly unlikely.

In contrast, all active managers think they can beat the market by picking the good stocks and avoiding the bad.

We Can’t All Be Above Average

The fallacy of the active argument is obvious on the surface: There’s no way all active fund managers can beat the market, because added together, they are the market. In a vacuum, we would expect half of these managers to underperform the market and half to beat it.

The problem is that all these managers want to be paid. Moreover, they ring up large transaction costs buying and selling stocks as they try to outperform. After fees and expenses, studies suggest that a strong majority trail the market over the long haul.

Passive investment solves that problem. Index funds are cheap to run and generally cheap to own. By capturing the market’s return at the lowest possible cost, these “passive funds” manage to outperform most active managers over the long haul.

More Than Just Stocks

While we’re thinking mostly about equity indexes here, passive investing can be applied to any market and any asset class, from corporate high-yield bonds to agricultural commodities.

The incredible range of markets that can be accessed by passive funds hints at possibly the most difficult decision that still faces all investors, whether passive or active: how much money to put in which asset classes. Many argue that the allocation decision is the most central one, and that allocation drives the risk and return in a portfolio far more than security selection. Passive investing allows investors to focus on this critical aspect without the distraction—and the expense—of picking individual securities within an asset class.

Some of today’s most aggressive macro-oriented investors use passive tools to make these active asset allocation decisions.

In short, there’s nothing passive (or uninteresting or lazy) about passive investing. Many of the most important choices remain, such as asset class allocation and selecting the best passive vehicle for the task at hand.

The Case For Active

While the data show that active managers struggle to outperform the market—net of fees—there are pockets of the market where a case can be made for active investing. For example, fixed income is a notoriously opaque and relatively illiquid marketplace. Unlike with equities, there’s no central exchange for trading fixed-income securities, and many fixed-income securities do not trade with anywhere near the frequency of equities. As such, there is no central pricing mechanism for fixed-income securities. This becomes even more pronounced the further away from sovereign debt you go. Once you get into municipals, junk bonds, senior loans or floating rate securities, there’s significantly less pricing consensus.

As such, there’s some merit to the idea that superior managers and analysis can generate outperformance in these markets. In addition, the neutral weighting mechanism in fixed income is value weighting, whereby the bonds with the highest outstanding face value receive the highest weighting in an index. This means the biggest debtors are given the highest weightings. Active managers can circumvent this issue by using their own proprietary fundamental analysis to pick higher-quality credits.

Still, these instances are the exception rather than the rule. History tells us that real outperformance is fleeting, not durable. Those managers who outperform one year are typically next year’s underperformers. Passive investing captures the market in a cost-effective, efficient manner.

Next: How To Run An Index Fund: Full Replication Vs. Optimization

Other Articles Of Interest

What Is An ETF?
What Is An ETN?
ETFs vs. Mutual Funds: How Do You Choose?

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