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Active Versus Passive: Which Do You Choose?

by Charles Rotblut, CFA

Active Versus Passive: Which Do You Choose? Splash image

How involved do you want to be with selecting individual stocks and securities? Though there is no right or wrong answer, it is an important question to ask. The answer has definitive implications for the types of investment vehicles you use. Two factors can help you determine the answer: your personal inclinations and the level of expenses you are prepared to incur.

Personal Inclinations

How likely are you to research individual stocks, mutual funds and exchange-traded funds (ETFs)? Consider both your personal interest level and your available time before answering. Do you enjoy analyzing financial statements, dissecting business models, staying on top of relevant financial news and sorting through fund return information? Alternatively, how much time can you realistically put into managing your portfolio?

Some individual investors truly enjoy analyzing stocks and bonds and set aside time every week (or even every day) to do it. Others find quarterly earnings reports to be the most boring thing they’ve ever read. Some really want to get into the nuts and bolts of security and fund analysis, but just have too many other demands on their time to do it regularly.

If you are someone who is willing and able to analyze individual securities and funds, you are more suited to following an active investment strategy. Active management means you decide which stocks, bonds, mutual funds and ETFs to invest in, and when to sell them. Alternatively, if you are someone who does not want to do the regular analysis or if you lack the time to do it, a passive strategy might be more suitable. A passive strategy involves holding mutual funds and ETFs that are designed to mimic the returns of an index, such as the S&P 500.

Expenses

A passive strategy can incur the lowest level of investment expenses. Because the composition of the major market indexes does not change very often, little buying and selling occurs within passive mutual funds and ETFs. In addition, since the fund managers merely have to follow an index, overhead costs are lower. The cheapest (both in terms of annual expenses and tax costs) mutual funds and ETFs are those that track well-known indexes. Opportunity cost can occur, however, if an active strategy produces a higher return than a passive strategy. You lose the performance advantage you would have achieved if you had followed an active strategy.

Active management carries higher expenses. Individual securities are bought and sold more frequently, which results in greater transaction and tax costs. If an actively managed fund is used, annual expenses are also higher because of the additional costs of hiring a team of analysts to research individual securities. Opportunity costs can occur if active management results in returns that are below performance of the broad market indexes. You lose the better returns you would have achieved if you hadn’t followed an active management strategy.

You Can Choose Both

The decision to use an active or passive strategy is not an either/or choice. Rather, you can combine both. The advantage of combining the two strategies is that part of your portfolio will always perform in line with the broad market indexes. At the same time, you give part of your portfolio a chance to outperform the market by selecting good stocks, bonds and funds.

Regardless of what type of strategy you choose, you will need to regularly review your portfolio. Even a passive strategy does not exempt you from knowing what is held in your portfolio and ensuring your allocations are in line with your long-term financial goals.

Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/CharlesRAAII.


Discussion

Angelo Ciavarella from NC posted over 3 years ago:

After more than 25 years in investing,the Vanguard 500 index is the only fund that lost me money during the past 10 years.I have had good success with carefully researched active funds,and because of my age I now favor balanced funds.


Augustine from TX posted over 3 years ago:

IT IS INTERESTING TO NOTE THAT THE VANGUARD 500 INDEX PERFORMANCE LOST YOU SOME MONEY. DEPENDING ON YOUR CURRENT INCOME LEVEL AND RISK LEVEL,I WOULD NOT FAVOR BALANCE ENTIRELY,BUT WILL DIP INTO SOME MODERATE GROWTH FUNDS.


Kenneth from ID posted over 2 years ago:

The empirical data show that over the very long term on a risk-adjusted basis, neither timing strategies nor stock-picking strategies have added value. This is especially true for taxable accounts. Though there are some funds and managers that have "beat the market" over a 10 or even 20 year period, they are very few, difficult to identify in advance, and they frequently under-perform in subsequent periods.

It is interesting to note that Benjamin Graham, in one of his last interviews, effectively endorsed index funds and said that it may no longer be possible to identify the stocks that will out-perform.

In addition, Warren Buffet has a 10 year wager that an S&P 500 index fund will beat a set of hedge funds selected by a hedge fund manager. It is four years into the wager and they are virtually tied.

Given the difficulty and uncertainty in beating the market, why not pick the allocation that meets your situation and buy the appropriate mix of index funds given that they will beat the vast majority of active funds over the long term?


Ferdinand from DE posted over 2 years ago:

The topic active vs passive investing is to simple and deserves further discussion. For example, Investing in active international funds may be preferred to investing in international ETF's ; some Bond Investment categories
can only be invested in mutual funds etc. AAII can explain why this is so!

The soundest investment strategy is still a well balanced portfolio with an asset allocation using active and passive funds, consummate with the individual investors risk profile - and the discipline to rebalance the portfolio at specific intervals to "sell high and buy low". A mathematical analysis would show that with rebalancing , the investor would not have lost money with the Vanguard 500 Index.

At least for me, successful investing in active funds and ETFs requires a disciplined approach, selecting a balanced portfolio, an asset mix of equities and bonds according to the investors age based risk tolerance. THere is no way around investing some time to manage a portfolio - loosing money by chasing the hot fund of the day is easy, making an adequate return on one's investment requires some diligence.

AAII provides all the tools and research needed for the individual investor to be successful over time. Also, Ihave found the regional chapter meetings to be very useful in the learning process that really never stops.


Devin from NE posted over 2 years ago:

When the bond bubble bursts, allocation models will go out of favor.


Vern from CA posted over 2 years ago:

In my active and passive investing experience over 55 years, I believe that using a personal evaluation progam and the Investor's Business Daily- monday edition for data provides a disciplined effective basis for development of a personal mediun risk, asset allocation Portfolio. The Portfolio will consist of selected high quality, Buy/Hold catgory rated individual stocks,REITS and bonds provides a capability of beating other investment methods and eliminating all hidden and active management fees. My personal methods and results are shown on website lifetimestrategies2009.com


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