It’s one of the most contentious debates in investing.
Perhaps a more important question: which approach will be superior over the long term, active or passive investing?
Active investing is when you proactively move assets (buying and selling) with the goal of beating relative market performance as measured by an index. Relying on trend analysis and your past experience, you seek to buy individual stocks, sectors and/or fund managers when they appear low with the plan to sell them when they’re higher. If you guess correctly, you have the potential for significant returns. But if you’re wrong, the results can be costly.
Passive investing is when you buy a diverse mix of assets and reallocate your funds only when rebalancing is necessary to return to your original portfolio weightings. You own broadly exposed instruments like index-linked funds and exchange traded funds. And you choose components of your portfolio based on their tendency to move in dissimilar directions rather than attempting to always “outsmart” the market.
The labels “active” and “passive” are somewhat insufficient. Active investors will often place their portfolios with fund managers who have shown a past ability to beat the market for some period of time and hire them (paying their fund expense ratio) to take the active role. Meanwhile, passive investors don’t just sit on their hands. While they certainly avoid the costs and risks inherent in active speculation, their actions can be to routinely rebalance their portfolios and periodically reviewing their long-term plans, like how we at Efficient manage our portfolios.
So who’s better?
A new measure from Morningstar is giving the nod to passive investors. According to the “Wall Street Journal”, the investment research firm’s first Active/Passive Barometer report, which looks at fund results over the one-, three-, five-, and ten-year periods through 2014, found that actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons.1
The report also found that active funds had a higher mortality rate. Many disappeared through mergers or closing over the long-term. And guess what happens to the returns history of yesterday’s “All Star” fund when it closes or merges with another fund? Its poor performance is no longer counted. This is known as Survivorship Bias and a topic for another time to be sure.
The two main weaknesses of active investing are the unpredictable nature of the market and the higher fees associated with buying and selling assets.
Over the long haul, even the most brilliant minds on Wall Street can’t consistently and predictably outperform these two drags on portfolio performance. So even though you’ll always be able to spot the equivalent of last week’s lottery winner in the financial press, hiring him or her after they’ve made somebody else great returns could prove a disappointing strategy.
However, passive investing isn’t without its compromises either. There is no free lunch. Holding through periods of significant market volatility requires time-horizon level discipline. That means, as a passive investor, you have to be clear about what a portfolio’s expected downside risk is IN ADVANCE so that you can align your expectations accordingly. The goal is to maintain holdings that are diverse enough to help balance out significant moves and remain disciplined enough to stick with your plan when daily or even quarterly news headlines about major markets seem like a four-ticket roller coaster.
To help ensure you’re clear about your investment portfolio(s) and progress toward meeting your financial goals, be sure to check with your trusted advisor periodically. And, as always, if you have questions or concerns, be sure to reach out to them right away.
Disclosure: The views expressed herein are exclusively those of Efficient Advisors, LLC (‘EA’), and are not meant as investment advice and are subject to change. All charts and graphs are presented for informational and analytical purposes only. No chart or graph is intended to be used as a guide to investing. EA portfolios may contain specific securities that have been mentioned herein. EA makes no claim as to the suitability of these securities. Past performance is not a guarantee of future performance. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. You should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. You should note that security values may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Investing in any security involves certain systematic risks including, but not limited to, market risk, interest-rate risk, inflation risk, and event risk. These risks are in addition to any unsystematic risks associated with particular investment styles or strategies.
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