Once again, this fall, our nation is more divided than it ever has been. Often seemingly innocent dinner-time conversations swerve into “that” divisive subject, and once strong friendships and family relationships become strained. Far too often each side decides to simply not discuss “that” topic anymore, while smugly enjoying the high ground of their intellectual superiority.
And I don’t mean Republicans and Democrats.
What so sharply divides this great nation? The question of active or passive investing. Like most disciplines, investing has it’s polar opposites. Active investors think that passive investors are lazy, and passive investors think that active investors are crazy. But who are these aggressive adversaries?
Active Investors – Active investing is how we have always done investing. Active investors look at a particular market, like big companies in the United States, and do all the necessary due diligence to pick the companies they think will perform the best. They will invest in and “actively” manage that portfolio aiming to outperform the market as a whole. They want to “beat” the market. And if they are good at it, they can make a lot of money.
Passive (Index) Investors – Passive investors, on the other hand, don’t try to “beat” the market, they try to “be” the market. Rather than picking the companies that will outperform their markets, they simply invest in the entire market. While they are not going to “beat” the market, you will pay a fraction of the cost of an active investment.
When they were first introduced in the 1970s, passive funds were not well accepted. Who could possibly think that investing in the entire market would be better than picking the best companies? But approaching 50 years later, more than half (51.5%*) of the mutual fund and ETF markets are passive investments.
So which is better, active or passive? While there are a lot of variables to consider, the best answer is, “It depends . . .”
. . . on the investor – Active investing requires a high level of due diligence to determine which active manager to use. Picking a good active manager will have an impact on performance. Generally, if the investor can do the due diligence themselves, or if the account is being advised by an independent financial advisor (like some 401(k)s), going active may be a great idea. If the account is an IRA, where the individual account owner is unable or unwilling to do the due diligence, a passive approach may be better.
. . . on the market – The more efficient the market, the more favorable for the index approach. An efficient market, like the US large cap market, is one where information that could impact on the market is immediately reflected in the performance of the market. By the time you and I hear about it, the S&P 500 has already adjusted for the news. It is harder for an active manager to beat an efficient market. But markets that are not as efficient, like U.S. small-cap international emerging markets, can favor the active manager.
. . . on the performance of the market – Passive mutual funds are “all gas and no brakes.” For example, an S&P 500 index fund is entirely invested in the S&P 500. If the market is roaring, the passive fund will often do better than their active counterparts. When the market is falling apart, an active manager, who has the flexibility of overweighting defensive investments may do better than a passive fund.
. . . on the risk profile and expected return – If your portfolio is aggressive, and you are targeting an 8% return, a 0.50% fee reduces your return by one-sixteenth. But the same fee will reduce your conservative portfolio, targeting 4% return, by one-eighth. The more conservative your portfolio, the more cost conscience you might be.
So which team should you join – team active or team passive? Like many questions in the finance world, the answer comes down to diversification. You diversify the types of investment you use; you may diversify your tax treatment with Roth and pretax accounts; consider diversifying your investment approach with a little bit of active (in less efficient markets) and a little bit of passive (in more efficient markets). This will moderate your fees while allowing for some of the advantage of active investments in a market downturn.
It also means you can stop arguing about investments and go back to arguing donkeys and elephants.
If you have any questions, please contact your Francis financial planner or reach out to us via phone at 866.232.6457 or email at info@francisway.com.
