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Investing: Active Vs. Passive

Summary

With the advent of the index fund in the 1970’s, the battle began: actively managed funds versus passive index funds. Which belongs in your investment portfolio?

Actively managed funds have people responsible for deciding which companies to invest in and include in the fund. These funds will typically have a strategy to invest in a certain sector or style such as US large-cap growth companies or emerging market companies.  

Passive funds on the other hand, use rules that define which companies to include in the fund. Examples include the S&P 500 (500 largest US companies) or the Russell 2000 Index (the smallest 2,000 companies in the Russell 3,000 index).  These funds typically have very low ongoing expenses since no one is employed to actively research and make investment decisions.

This obviously begs the question: which is better for your investment dollars?  The research is in: the chances of you picking an active fund that outperforms a passive index is very small. In virtually every category of public investments, the index funds outperform a majority of the actively managed funds.

Investing in low-cost index funds has other benefits as well:

  1. You don’t waste time researching which manager to pick
  2. You don’t worry about a year of underperformance and if you should switch managers
  3. You can automatically add funds each month with no ongoing effort

It’s comforting to know that you will not only make more money over time but also spend less energy using passive index funds. Not often in life do we get such a win-win scenario.

Other topics discussed include:

  • Should you pay a wealth manager or financial advisor to “actively” manage your portfolio?
  • Are there scenarios where you recommend using actively managed funds?
  • Why do so many people still invest in actively managed funds?

    Resources:

    Photo by Jeremy Bishop on Unsplash

    Transcript 

    Mike: [00:00:00] Welcome to financial planning for entrepreneurs and tech professionals. I'm your host, Mike Morton, charter financial counselor, and financial advisor. Do you want to invest in active or passive funds? On today's on-air radio show with Matt Robison we discussed the difference and let you know the verdict is in. So listen up to make sure you have the right portfolio working for you. Enjoy the show

    Matt: [00:00:27] . I'm Matt Robison I'm joined as always by Mike Morton of Morton financial advice. Mike how are you. 

    Mike: [00:00:33] Doing well this morning, Matt. 

    Matt: [00:00:35] Excellent. That's always better than doing badly. I have a question for you here. There's an age old debate on , you want to invest. You want to manage your assets and the question is, do you really want to manage your assets? Do you want someone else to manage your assets?

    It's a question of active versus passive. Now, when you're writing, I know the answer is, avoid the passive. Maybe being passive is good. I don't know that seems to be the question of the day active versus passive. How involved in terms of management, do you want to be, how much do you want to pay someone else to do the management of your assets?

    And we're going to explore all of that. So   why don't you start us off here? Maybe we can just define what we mean by active versus passive.

    Mike: [00:01:29] Yeah.

    absolutely. And it's a great question is the age old debate, on mutual funds, ETFs, how you're going to invest your money now there's a lot more choice and we've talked about choices, not always being, the overwhelming number of choices, not always good for happiness. But definitely something that you got to make a decision on.

    Now,  it's funny, when you mentioned, do you want to manage your investments yourself or pay someone else to manage them or actively managing. My mind went to, having wealth managers for your portfolio, or are you going to do it yourself, at Vanguard or fidelity and pick the funds.

    And so that's a, slightly different topic than we're diving into today. That's more around do it yourselfers, picking the funds in your 401k or in your brokerage portfolio versus, outsourcing that to somebody else to take care of for you 

    are you going to mow the lawn and fertilize it and do it yourself, or you just want to hire that landscaping crew to come in there every week and keep it looking pretty. But the active versus passive, let me define that in terms of the investments that are choices within your 401k, within your brokerage account, ETFs mutual funds, you can pick funds that follow an index.

    And that would be a passive way of investing. So there are these indices, there's lots of them now, but you can think of the S and P 500, the top 500 companies here in the U S that's pretty passive. It's an index, the top 500 companies  they change, now, and then a couple of times a year, and you can invest in mutual funds or ETFs that.

    That index that hold those 500 companies and no, one's really making the decisions like, Hey, I think this company is going to do really well. Let's put our money here. It's just passively tracking that index versus an active man. So you invest in a fund where there are managers deciding where to place the money.

    They say, oh, I think these five growth companies look really good. Let's put some money in those and these other 10 companies. So maybe they hold 15 companies or 25 companies or whatever it is, and actively making trades throughout the year to try to beat those indexes that they're following or try to do better than some other strategy.

    So that's the. Decision that you have as a personal investor, do you want to invest in an actively managed fund or just a passive index fund? 

    Matt: [00:03:47] got it. So I see the distinction that you're drawing here. You could yourself be an active investor. You could make those decisions on your own and be trying to beat whatever index you're benchmarking against, or you could have someone else do that.

    And you could also be a more passive investor sitting back, not trying to choose individual investment vehicles, individual stocks. And so that's what you're focusing on here is just that active versus passive decision

    Mike: [00:04:22] yeah, just within the funds themselves. That's what I want to focus on today. If you want to invest in the us stock market, Hey, I'd like to put $10,000 into the us stock market. You have a choice. Do I just put that into the S and P 500 or the total us stock market? Indices. They were very passive because no one's actively trying to pick the next best company.

    They're just tracking the entire stock market the large cap the S and P 500, or you can take that $10,000 and say, I think there's a manager out there who can. Do really well better than that. And so I will pick this fund, run by a manager and put my $10,000 into that mutual fund.

    And hopefully they do really well. So that's the distinction today is index funds. We're just going to call them index funds. Those are the passive ones versus the actively managed where managers are picking individual companies or sectors to invest in. 

    Matt: [00:05:18] Is this a question you should be asking early on in, your asset allocation process, in your investment process? Why does the whole question matter?

    Mike: [00:05:29] Yeah.

    It matters because in all investing, you're trying to make the most money possible. That's usually one of the games, although I would argue it's not. What you should be aiming for. This is not speculation or trying to gamble or trying to make the most as quickly as possible. It's really a lot of it has to do with investing smartly with your money over a long period of time.

    And that's how you achieve real wealth without taking on too much risk over the years. But that's why it's important to think about. Trying to make the most money possible? So if the active managers. Are doing better? Maybe we want to focus our money there but if the passive indexes tend to do better, maybe we want to focus our money there.

    So that's what we're looking at in terms of where to place your money so that you can do the best you can.

    Matt: [00:06:16] there a general rule of thumb as to which approach is better for most people?

    Mike: [00:06:22] The first choice, like you said, Matt, I would look at where you're investing your money. So before you get to active or passive. Let's first save money. We talked about that. You don't get to invest your money until you've saved money. So first you have to save it. Then you've got emergency funds and other things, but finally get to, Hey, I can invest some money in my 401k or in brokerage.

    First question I'd ask is make sure you get the up automatic savings. Automatic investing  do you have a diversified portfolio, U S international, those things then within each of those asset classes, we call them. 

    Matt: [00:06:55] Yeah,

    Mike: [00:06:55] Large companies in the U S small companies in the U S large companies international.

    Okay. All those different classes. That's where you can get into. Okay. Do I pick an active manager or a passive index fund? All right. Now I'll give you the bottom line up front. The research is basically in that, that the index funds beat the active managers over the long-term. 

    Matt: [00:07:20] As a general rule of thumb.

    Mike: [00:07:22] Yeah. Yeah. Now where do I find that there's a lot of research because again, in the investing world, we want to make the most money possible. So there's tons and tons of academics. Everybody on wall street, , all the analysts doing research, trying to figure out how do I make the most money possible.

    So there's tons and tons of research. And one of the things, the academics. Are active versus passive. Hey, which is better. They take all the active managers in the say us large cap space. So the S and P 500 would be the index. And they say, okay, everybody, that's investing in large us companies trying to beat that index who does better now year in and year out.

    It's a toss up 50, 50, active managers could maybe outperform in one year versus the index maybe 50, 50, but over three years, five years, 10 years. The active managers have a very hard time keeping up 

    Matt: [00:08:13] Why is that?

    Mike: [00:08:14] why is that? Because it's really. That's the bottom line.

    It's really hard to beat the index. You have to consistently, and that's a real word here is you have to consistently find the best companies that?

    will earn more money than just the regular index. It's hard to believe. It seems like we're always hearing great stories, look at Amazon and apple and Facebook, and they've just made a killing over the last five or 10 years and they're going straight up, it's easy to look backwards and tell a story like, ah, it's so easy to pick those, but it's really not.

    That's what the research. 

     Matt: [00:08:48] It reminds me a little bit of weather forecasting    weather for his things is actually improved a great deal, even within the last 10 or 20 years. But I don't know about you, but I just remember. Like even growing up, you'd watch the weather forecast and the meteorologist would be pretty good at saying, let me tell you what's happened over the last few days.

    It all makes sense. Now, not so accurate when it comes to here's, what's going to happen a week from now that has improved, but , I could see how it would be pretty tough to do on a forward-looking basis. I sensed I could be wrong, but I sensed a little, it's a bit of a, but a little bit of a caveat in your general rule of thumb earlier, maybe I'm wrong, but you mentioned that there are different market segments.

    Are there situations, or are there segments where a more active approach, more active management does actually outperform and might be a better fit for certain events?

    Mike: [00:09:42] yeah. So let me first go back and tell you where I'm getting some of the information. So listeners can look this up so that the SPIVA report SPIVA this is put out by standards in poor, the S and P group. Does it report active versus passive? Now of course they create indices. So  with anything, when you look at research immediately think wait, who are these guys coming up with the research and where this is their funding coming from.

    So these guys do create indices. So they have a, incentive to show that indices do better than active management. But they have looked at a lot of these asset classes and compared again, the hundreds of active managers versus just the index and in a one-year I'm looking at the S and P 500.

    So that's top 500 companies, large companies here in the U S in a one year only 40% outperform, just the straight index. And when you go to five years, only 25% outperforms. So your chances of picking. One of those 25%, it's going to outperform becomes very hard. So not only do you have to, decide to go inactive, but you have to find the one that's going to outperform over five years and stick with it.

    And that's the real, other problem that is within a one-year it's very volatile. The one you picked, might, but it might underperform. And if it underperforms in one or  three years, are you gonna stick with it? Or are you going to switch to another.

    And the problem is when you get to persistence and this is can that same manager outperform year in and year out. And we find that again, the research says it's very hard. And so if you pick, the top fund for the last three years, it's more likely it will not be a top fund for the next three years.

    In fact, you're better off picking one of the worst funds for the last three years has a better chance of outperforming over the next three. 

    Matt: [00:11:30] interesting. So sounds like it's in part hard to pick  You may have made the right decision, but you may not have the patience to stick with it. If you adopted a strategy for the right reasons and your thinking was clear at the outset and it doesn't go well initially, you start rolling And you're like, Hey, if I get a six, I win and you roll it the first 10 times you don't get a six.

    And you're like, ah, maybe I should switch numbers. No, your odds are actually not any worse than not any better, but they're not any worse. You should probably stick with it. But it's very hard psychologically for people to feel that. And so people may be part of the reason. It sounds like people may not do as well in some of these active management approaches is.

    They start to fall into these psychology traps.

    Mike: [00:12:22] that's exactly Right. Matt. So luckily not only are index funds outperforming the active funds. They're also easier to stick. So it's even better. It's an even better choice to go with the low cost index fund portfolio because they outperform the active managers and they're easier psychologically to stick with and they take no work.

    So its really a great approach. Now you asked, are there areas of the market where maybe we should take an active approach? 

    Matt: [00:12:55] I'm not letting you wriggle off of that one.

    Mike: [00:12:57] Yeah. Yeah. So I'll get to that. Some there's do what we call like a core and satellite approach. So some listeners might be familiar with that where  managers will say, Hey, 70% of our portfolio will be in these index funds, but certain areas we'll use  satellite.

    We'll do active managers with a small percent, 20, 30% of our overall portfolio. We'll get some active managers because we think we can outperform. I don't think that's a great approach because again, overwhelmingly the index. Perform better than active managers. Over 3, 5, 10 years, you're getting to 70, 80, 90% of the index fund will outperform.

    So again, only 10 to 20% of active funds will outperform over five to 10 years. So small that why would you even have satellite, even if it's a small percent of your portrait? Now let's get to, are there areas of the market where maybe it does make sense? One word does not make sense. Just continue on that is fixed income.

    We know that interest rates are so low that you're barely making anything on short-term bonds and interest rates. So that's a place that you really want to get as low cost as possible when you're only earning half a percent and your active managers charging. A quarter percent  you're already losing out, right?

    So that's a place that you really don't want to go. But in bonds, there is some argument for active managers around corporate bonds. Corporate bond landscape is vast. And when you do research anywhere where research is going to gain you. So real estate is one.

    where if you really know a certain area, you have an advantage because not everybody in the country is going to know your particular area.

    So this is where managers can really get in there and understand the different corporate landscape and maybe be able to outperform a little bit on those corporates. 

    Matt: [00:14:48] interesting. And so you mentioned earlier that there is a strategy of essentially.  Picking a small satellite, right? Like a small percentage of your investments and putting them into a more active managed approach. It sounds on the surface, like diversification. It sounds a little bit like, Hey, here's a small amount it's not going to make or break me, why don't I take a risk here and see you for a few years?

    I can hit lucky with it. And maybe I would be invested in, a portfolio of stocks or assets that I wouldn't hit with a broader index fund necessarily. Isn't there an argument for that kind of thing. 

    Mike: [00:15:30] yeah, let me say this first. I said that we should first have our diversified portfolio, us international, large, small, all of those have indices. So you can get a passive investment in any one of those asset classes. And I told you, Matt, that there's only a 20% chance that your active fund will outperform over 10 years.

    So  why do you want to take that small percent chance of outperforming? 

    Matt: [00:15:57] Yeah, that makes some sense. Now let me ask you the inverse question. If you're making such a compelling case and look, we all know people do nothing but follow scientific evidence. That's all we do is a society is listened to the evidence, what the experts say.

    That's what we do. So maybe I know the answer to this question, but if the evidence is in, funds are still very much a thing. Why are they so much of a thing?

    Mike: [00:16:22] Yeah, I think there's a few different reasons. One is exactly like you just said, Matt it's storytelling, right?  We are humans. We love the stories.  Why don't we just eat salads every day? We know it's better for us because it just doesn't sound right.

    And marketing strategies they have this figured out, and then also the digital strategies, Facebook all the social media, how they keep you entertained on those sites. They have figured out the human psychology and trust me. So has  The financial industry that is trying to lobby for your dollars.

    Hey, why don't you put your dollars with fidelity? Why don't you put your dollars with Schwab? They make money on your dollars. That's they're a business, right? And so they figured out how to get you, compel you to buy into the storytelling. So that's a big part of it is that these funds.

    Have lots of stories about why it's better, how they're going to do better and all that. And it's fun and it's easy to fall for. Okay. So that's one thing?

    the next, I think is a fear of missing out. You hear your neighbor really killing it with their investment in Amazon or their strategy they were using.

    And so we fall for the stories because of the fear of missing out. And saying, Yeah. I want to get involved in that sector. Oh, that's really hard. Growth stocks been killing it for the last five years. Why would I just not put all my money into the Fang stocks and watch them go to the moon? until they don't.

    Okay. .

    That's another one. And then finally we were wrangling with wall. And wall street Is a massive business. Employing tens of thousands of analysts and investors and strategies, and they are there to make money, their companies as well. And so you just have to be careful about what you're getting into when you've got all these different forces, compelling you to try to put money in certain areas.

    Matt: [00:18:13] Is there also a factor, just going back to the top of the show, where we were talking about the distinction you were making between active management. And doing it yourself. Part of the argument that I often hear, and I think a lot of people feel is, you know what? get that I'm implicitly, I'm paying more than implicitly.

    I am explicitly paying to have someone else take charge of this, but I actually want that. I want to just every year, I just want to say, here's my money. I trust you. You take care of everything. Is there some value in that? Is that rational to some degree?

    Mike: [00:18:51] Oh, there's a ton of value. Let's go back to the same conversation about taking care of your lawn. Some people love it. They love going out there and mowing it and trim in it and cleaning things up. And it brings them a lot of joy, right? Same in investing. There's tons of investors that love. Just looking at the funds and saying, how's my portfolio, my, and my diversify, in the right stocks and bonds at us and international.

    And they can stick with it. And it's perfect. There's other people that just want outsource the whole thing. Look, I do not want to take care of my lawn. I just want it to look nice when I go outside.  Perfect. And so the same is true with financial advisors or wealth managers where you're just saying, look, I want someone else to do this.

    It's getting to be a really big dollar figure. I do not want to have arguments with my significant other about what we're doing. We're just going to pay someone else to check in with us a few times a year, know our goals and help manage towards those goals. 

    There's a tremendous value for doing that for certain people. 

    Matt: [00:19:47] It makes sense to me, it sounds like the bottom line, which you already gave upfront is most of the time probably makes sense more passive strategy, but maybe combined with some services that are done for you. Some not doing it yourself. An active management approach could make sense in certain circumstances for some people, Mike Morton financial.

    Yeah. Thanks for the big rundown. 

    Mike: [00:20:11] Thanks, Matt

    . Thanks for joining us on financial planning for entrepreneurs. If you like, what you heard, please subscribe to and rate the podcast on Apple iTunes, Google play Spotify, or wherever you get your podcasts. You can connect with me on linkedin or mortonfinancialadvice.com. I'd love to get your feedback. If you have a comment or question, please email me at financialplanningpod@gmail.com. Until next time thanks for tuning in