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What Is the Difference Between Active and Passive Investing?

What Is the Difference Between Active and Passive Investing?

Client Question:  What is the difference between active and passive investing?

Advisor Answer:  In general, portfolio managers who engage in active investing are trying to outperform a benchmark (e.g. the S&P 500) while passive investors aim to invest in the benchmark itself.  Given that data show a vast majority of active managers underperform their benchmarks, passive investing has become much more popular. This can be seen in the explosive growth of investment companies like Vanguard offering passive strategies.

Traditional Active vs. Passive Investing

Traditionally, active management has referred to portfolio managers who try to invest in a group of companies within an asset class such as U.S. “large capitalization” companies (i.e. companies worth more than $10 billion) that outperform the asset class at-large.  In order to outperform the asset class “at-large,” it is necessary for there to be a benchmark that represents the asset class for the portfolio manager to compare himself or herself to. A well-known benchmark for U.S. large capitalization companies is the S&P 500, which is an “index” (i.e. portfolio) of the largest 500 publicly traded companies in the United States.  It is the norm for actively managed funds to have significantly higher fees than passive funds. For example, I normally see prospective clients with funds that have expense ratios of over 1.00%.

A passive investment approach would be to create a portfolio that simply tracks the S&P 500 index in a low-cost manner.  The index is a statistical measuring tool used to measure the performance of an asset class, whereas an actual mutual fund or exchange traded fund is the vehicle an investor uses to invest in the index fund.  Vanguard offers the passively managed Vanguard S&P 500 ETF (ticker symbol VOO) that aims to mimic the performance of the S&P 500 index. As of April 11, 2019, this fund has over $459 billion dollars in assets under management, and the expense ratio is 0.04%.

Strategic vs. Tactical Asset Allocation

As mentioned in the “Advisor Answer” above, the reality is that a vast majority of active portfolio managers underperform their asset class benchmarks.  The image below from the S&P Dow Jones Indices SPIVA (S&P Indexes vs. Active Management) scorecard shows 92.33%, 94.81%, and 95.73% of large, mid, and small cap active portfolios managers underperformed their benchmarks, respectively, over a 15-year period (see red rectangle below).

This is the very reason why passive investing has become so popular.  Perhaps as a consequence of the relatively poor performance of traditional active managers, active management itself has changed.  Instead of only aiming to outperform an individual asset class, which the Morningstar study shows is very unlikely, active managers may instead try to outperform strategic asset allocations through a process called tactical asset allocation (more on this below).  Depending on the active asset manager, he or she may try to do tactical asset allocation in addition to actively trying to outperform individual asset class benchmarks.

A strategic asset allocation is based on an investor’s risk tolerance, time horizon, and investment objectives.  For example, if a client is within five years of retirement, I might recommend a strategic asset allocation of 60% stocks and 40% bonds.  The sub-asset classes of this allocation may look like this:

  • Stocks – 60%
    • US domestic:  50%
    • International developed markets:  35%
    • Emerging markets:  15%
  • Bonds – 40%
    • US government bonds:  70%
    • International developed government bonds:  20%
    • Emerging market government bonds:  10%

Unless an investor’s risk tolerance, time horizon, and/or investment objectives change, a portfolio manager exercising pure strategic asset allocation would maintain this allocation regardless of the political or economic environment.  If the stock market did extremely well relative to the bond market, the passive portfolio manager would simply rebalance the portfolio. For example, let’s say you invested $60 in the stock market and $40 in the bond market, and the stock market increased 50% whereas the bond market stayed flat.  In this case, you would have $90 in the stock market ($60 X 1.5) and $40 in the bond market. Rebalancing would decrease your stock position to $78 and increase your bond position to $52 to maintain the 60%/40% split set in the strategic asset allocation. Over time, re-balancing has been shown to help investor performance.  One reason this may be the case is that re-balancing necessarily sells an asset when it has increased relative to another and buys an asset when it has decreased in value relatively to another (i.e. buy low and sell high).

Active tactical asset allocation is when a portfolio manager will change either the major asset allocation weightings (e.g. stocks and bonds) and/or the sub-asset allocation weightings based on that portfolio manager’s opinion of the market environment.  For example, if the portfolio manager believes the stock market is overvalued, he or she might decrease the stock allocation from 60% to 50% and increase the bond allocation from 40% to 50%. The idea is that these are short-term changes to take advantage of short-term market opportunities; however, despite these short term changes, the long-term asset allocation of the portfolio should more or less resemble a 60% stock and 40% bond allocation (i.e. the portfolio manager is supposed to switch back to the long-term allocation when the previous short term opportunity is no longer there).

This all sounds great, right?  Why wouldn’t you want to invest your money with an active tactical asset allocation manager who says he or she will become more conservative before the market is going to go down and become more aggressive when the market is about to go up?  Not surprisingly, the vast majority of tactical managers fail to deliver. Morningstar, a widely recognized investment research firm, conducted a study of strategic asset allocation vs tactical asset allocation.   The graph below from this study shows the performance of Vanguard’s 60% stocks and 40% bonds strategic asset allocation fund (VBINX) vs. the aggregate performance of the tactical asset allocation category (orange line).  

According to the Morningstar study, “Over the past 15 years through December 2018, the average tactical-allocation fund returned 3.4 percentage points annually, lagging Vanguard Balanced Index by 3.2 percentage points per year with similar risk. This underperformance has been consistent, too. Vanguard Balanced Index beat the tactical-allocation category average in every rolling three-year period during the trailing 12 years through December 2018.”  

And to put the cherry on top, this study only includes the tactical asset allocation funds that actually lasted from 2007-2018, which presumably were the best funds.  Of the 125 tactical asset allocation funds that opened at the end of 2008, 57 of them “shuttered” (i.e. closed) in many cases potentially do to relatively poor performance.

Warren Buffet’s Bet

Perhaps the most famous illustration of passive vs. active management was a $1 million bet Warren Buffet made (and won) with hedge fund manager Ted Seides of Protege Partners (a New York money manager).  Buffet bet Seides that, over a ten-year period from January 1, 2008 to December 31, 2017, the S&P 500 would outperform a portfolio of hedge funds selected by Seides. Over this time period, the S&P 500 returned 7.1% per year while the portfolio of hedge funds returned 2.2%.  Thankfully, Warren Buffet donated his winnings, which actually ended up being $2.2 million, to Girls Inc. of Omaha, a leadership program for young girls.

Determining Your Appropriate Strategic Asset Allocation

The major take-away is that one should set the appropriate strategic asset allocation and stick with it.  The hard part is determining what the correct strategic asset allocation is. You can learn more about this by reading a past article titled, “How Aggressively Should I Invest.”

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