Investment management can be divided into two broad categories, each reflecting a fundamentally different belief system about how capital markets behave. These two schools of thought are referred to as passive and active.
Active vs. passive
Active management is when managers actively pick investments in an effort to outperform some benchmark, usually a market index. Passive management is when a fund manager attempts to mimic some benchmark, replicating its holdings and, hopefully, performance.
Active management is the traditional way of building a stock portfolio which includes a variety of strategies for identifying companies believed to have higher expected performance. One might focus on companies with impressive growth in sales and profits, companies with exciting new products, or companies with new management. Regardless of their approach, all active managers share a common belief, which is to purchase company stocks selectively based upon some forecast of future events.
Passive investment management does not make forecasts on the economy or stock market nor do they try to distinguish between attractive and unattractive stocks. Passive managers construct portfolios to closely replicate the performance of a well-recognized benchmark index such as the Standard & Poor’s 500 index, Russell 2000 index or the Morgan Stanley “EAFE” index.
A loser’s game
In his book, How To Win The Loser’s Game, Charles Ellis, a leading financial industry consultant, wrote: “Disagreeable data are steadily streaming out of the computers of the performance measurement firms. Over and over again, these facts and figures inform us that investment managers are failing to ‘perform,’ that is, to beat the market. Occasional periods of above-average results raise expectations that are soon dashed as false hopes. Contrary to their often-articulated goal of outperforming the market averages, the nation’s investment managers are not beating the market; the market is beating them.”
A 20-year study analysis by Dimensional Fund Advisors looking at the performance of mutual funds ending Dec. 31, 2018 found that only 23 percent of active stock fund managers and 8 percent of active bond fund managers outperformed their benchmark index.
Another study looked at the persistence of top-performing managers. Among equity funds that ranked in the top quartile of performance in their category in the previous period (2009–2013), only 25 percent also ranked in the top quartile in the subsequent period (2014–2018).
With this in mind, one reason to consider passive management is performance. A second reason to consider passive investing is cost.
An expense ratio is the amount investment companies charge investors to manage a mutual fund or exchange traded fund. The expense ratio represents all of the management fees and operating costs of the fund. It is calculated by dividing a mutual fund’s operating expenses by the average total dollar value for all the assets within the fund. According to Investopedia, the average expense ratio of a no-load, actively managed fund in 2019 was 1.10 percent compared to the average expense ratio for an index fund of 0.20 percent.
In addition to expense ratios, another cost associated with mutual funds is turnover cost. Essentially, mutual fund turnover typically measures the replacement of holdings in a mutual fund and is commonly presented to investors as a percentage over a one-year period. If a fund has 100 percent turnover, the fund replaces all of its holdings over a 12-month period. A mutual fund with a high turnover rate increases its costs to its investors. It has been estimated that turnover costs of actively managed funds are around 2 percent vs. 0.20 percent for index funds.
The cost for the turnover is taken from the asset’s funds, as opposed to the management fee.
While many investment management companies and financial advisors today advocate an active management approach to investing, academic research has shown time and again that it is very difficult to outperform the market. While there are numerous factors to consider before selecting an investment approach, I recommend you consider passive investing for a majority of your stock and bond market investments. A globally diversified portfolio of low-cost index funds, properly allocated and periodically rebalanced, should serve you very well. — Chris Nolt
(Chris Nolt is an independent, fee-only registered investment advisor and the owner of Solid Rock Wealth Management, Inc. and Solid Rock Realty Advisors, LLC, sister companies dedicated to working with families around the country who are selling a farm or ranch and transitioning into retirement.)
