Active vs. Passive Investing (Index Investing)

Active investing is what people commonly imagine when they think of investing. They imagine someone doing some analysis and then selecting securities in which to invest. When the analysis changes, the investor changes what is in the portfolio.

Passive investing, in its simplest form, simply means buying some security and holding it. When people talk about passive investing, they typically mean index investing. Index investing refers to buying and holding all the securities in a known index, such as the S&P 500 Index, at their index weight.

Following the advent of index investing in the 1970s, its popularity grew. Two reasons generally account for the growing popularity of indexing:

  1. Active managers tend to charge higher fees than index managers do
  2. Index investors believe in “The Arithmetic of Active Management”[1], which states active managers as a group must underperform relevant benchmark indexes

Marketers in the investment industry know to push investors’ buttons. For decades they have likened passive investing to giving up. At the same time they advertise which ever funds in their firm’s menu had outperformed, stoking investors’ envy and fear of missing out.

Yet indexing has continued to make progress. By the mid-1990s, it was common for large pension funds to allocate half their equity, if not half their fixed income as well, to index funds. For the largest pension funds the rationale was not due solely to belief in the Arithmetic, but also to an understanding about diversification: if you spread your assets among enough active managers, as a whole you’ll wind up holding the index anyway, except you’ll be paying active fees for the privilege.

It took a bit longer for indexing to become as popular with individual investors, but it caught on. Figure 1 depicts that by 2016 the share of US mutual fund market held by index funds was approaching 20%.

Index fund's share of the US mutual fund market

Being good at active management, that’s a human-capital skill. That person is going to charge high enough fees to absorb the rents that she’s creating. Investors are always going to be just as well-off buying passive, even if they can identify who the good active managers are. (Fama 2017)

Passive management typically does not cost much. Active management requires the same operations and extra compensation to pay for desirable value-added decision makers. That requires active managers to charge more in order to remain viable.

As Figure 2 depicts, investors can save 0.50% to over 1% in annual expenses by choosing index funds instead of active ones.

active vs. indexed fund costs

 

What is best for your situation?

If you understand the benefits of low-cost indexing and are comfortable investing all your wealth into index funds, go ahead and invest entirely into index funds.

If you don’t feel comfortable putting all your money into index funds, may we suggest you put at least half into index funds? That way you may benefit from indexing and still indulge whatever motivation you have to pick active managers. If you follow this path, do yourself a favor. After three years, compare the performance of the active investments you chose to the indexed ones, and ask yourself how likely your picks are to outperform in the future.

It is possible that your access to index funds might not be so attractive. It’s nice that index funds are cheaper than active funds in general, but how about the index funds available on your 401(k) menu? If you may invest in index funds that cost less than 0.20%, great. But what if they cost 0.75%? Or 1.0%? If the index funds available to you cost 0.85% while the active funds cost 1%, how much better off are you by going with index funds? In such cases, you might be better off spreading your assets among a variety of funds, both indexed and active.

Author: Tom Anichini

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