Actively-managed vs. Passively-managed Investing: Which one is more effective?

Actively-managed Investing:

An actively-managed investing approach involves picking both the “winning” and “losing” stocks. The active investing approach aims to get the highest possible return, exceeding the stock markets average return by taking advantage of daily or short-term price fluctuations. An active manager is looking to buy-low and sell-high. Sounds pretty straightforward right? To be successful, one needs to identify the “winning” stocks before they are winners, so that they can be bought when their prices are still low and held as their share price rises. At the same time, one also needs to identify the “losing” stocks before they become losers, so that they can be sold before their share prices drop.  The biggest challenge with the active-investing approach is being able to determine the winners and losers before their share prices start to move.  Everyone can see when a share price is sky-rocketing.  Unfortunately, investors who start buying shares after the share price has started climbing are late to the party, have not really bought-low and miss out on a good portion of the potential gains.  Likewise, if they are holding a stock who’s share price has started to plummet.  By selling after the share price has started to fall, they’ve also sold late, and lost out on gains because they have not sold-high.

The biggest challenge with the active-investing approach is being able to determine the winners and losers before their share prices start to move.

Actively investing also involves higher costs relative to passive investing for a number of reasons. There is a much higher rate of trading, as investors seek to jettison future “loser” stocks and add “winning” stocks that are on an upswing, which leads to higher transactional costs. In addition, an active fund manager will also be employing a team of stock analysts, whose job it is to research and find the “winners” and “losers.” They all have salaries, not to mention the salary of the fund-manager him- or herself, who would have the biggest salary. After all, the fund-manager “should” be worth the big bucks, because it’s their expertise that is going to find and pick the “winners” from the rest. The claim is that their expertise is “worth” the big salary because investors will get that value back when their investments outperform the market. All these costs are bundled up together and are charged to shareholders of the fund as a percentage of their holdings through an MER. Most actively-managed mutual funds in Canada have an MER between 2 and 3%.

Passive Investing

Over a multi-decade period, the stock market grows on average 7% a year.  Of course, there are years where you could see swings of 30-40% in either direction, but over an investment lifetime of 30+ years, the average annual growth of the market is 7%.

Passive investing has a simpler approach and only aims to replicate the average 7% market returns by using index funds.  (An index fund represents a segment of the market and tries to match a benchmark which is usually an index like the S&P 500).  Passive investors aim to capture as much of the long-term growth by buying and holding their investments for the long term and ignoring the short-term gains and losses.  Further, they aim to capture as close to the 7% average growth by keeping their costs as low as possible, using index funds that are far cheaper to manage than mutual funds. They don’t require big research teams to find stocks because the index (or benchmark) determines what stocks are going to be held in an index fund; an index fund will hold exactly the same stocks as the index. Further, there are far fewer transactions too. As a result of these lower costs, the MER on index funds is typically a fraction of those found on actively-managed funds – mostly somewhere between 0.05% and 0.25%.

Passive investing has a simpler approach and only aims to replicate the average 7% market returns by using index funds.

 

How do I decide between the two?

Personal finance is personal, but, most of the time, for most people, a passive investment strategy is going to be the most profitable option.  Statistics show that most of the time, the returns on a passively-invested index fund will beat comparable actively-managed funds after fees.  A minority of actively-managed funds will outperform their benchmarks.  The challenge is identifying which actively-managed funds will outperform their benchmarks ahead of time and having access to the best fund-managers. Often, they are inaccessible unless you have a very high net worth.  Most of us are not able to get the best fund managers to manage our money.  In addition, for every actively-managed fund that beats its benchmark, there are many that underperform their benchmark after fees (read my post on high-MER fees for more on the effect that fees can have on investment returns).  Most investors will be better off investing in low-cost index funds.

Personal finance is personal, but, most of the time, for most people, a passive investment strategy is going to be the most profitable option.

Warren Buffet, one of the most successful investors, left instructions in his will asking his wife and her trustee to invest his estate in index funds and government bonds after his passing:

One bequest provides that cash will be delivered to a trustee for my wife’s benefit…My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors…

This wasn’t the first time that Warren Buffett bet on index investing.  In 2006, Buffett wagered that the returns on an S&P500 index fund would be greater than any hedge fund over a ten-year period.  It took until July 2007 for Buffet to have a challenger, Ted Seides at Protegé Partners.  Their bet ran from 2008-2017.  Even with the financial crisis in 2008, the S&P500 Index yielded 7.1% compounded annually after fees.  The Protegé funds on the other hand, only returned 2.2% compounded annually.

How and why do low-cost index funds generally perform better than their actively-managed counterparts with higher fees?  The high costs kill returns.  The actively-managed funds need to make far more transactions.  Transactions incur costs for funds and investors, so for every transaction, a fund must perform an increment better to recover the costs of that transaction.  This doesn’t even take into account the costs of research that go into any and every transaction. This problem is compounded by the difficulty of picking the right stocks. Managers are tasked with picking stocks to buy before their prices have risen, and what stocks to sell before their prices have fallen. It’s easy enough to identify the winners after the fact, but predicting the futures is difficult.

While bitcoin is not a stock, the recent hysteria is useful for exploring the challenges faced by active-fund managers. If it were easy to predict the run-up and the subsequent fall, everyone (not just the relative few) would have bought into bitcoin when they were worth hundreds of dollars, and sold them when they hit their peak. One of the challenges is that there are two parties to every transaction. If it were easy, anyone who would have known that bitcoin would have had a monumental increase in value, would not have sold their bitcoin for hundreds of dollars knowing they would be able to sell them for $15,000. And conversely, when bitcoin was valued at $15,000, no one would have bought any knowing that they could buy them for $7-8,000 in the following months. No one can predict market fluctuations. Even the best fund managers who have a history of beating the market, aren’t able to consistently do so for the typical 30-year (or more) duration of an investment lifetime.

One of the challenges is that there are two parties to every transaction. If it were easy, anyone who would have known that bitcoin would have had a monumental increase in value, would not have sold their bitcoin for hundreds of dollars knowing they would be able to sell them for $15,000.

Passively-managed investments only aim to capture the average market returns.  However, the approach works well for investors because average market returns are actually above average!

Investing Quick Reference Guide

This post is an introduction to some of the concepts and terms of investment that will appear on this website and throughout financial literature.

Investing is to use the money you have now, to create more money in the future.  You can invest by loaning money to someone using bonds, GICs, or savings accounts.  You can also purchase stocks or shares of a company for a share in their profits, or real estate for the income that it can generate.

Interest is the money that you would receive in exchange for lending someone or a bank your money.  Interest on deposits in savings accounts are usually paid once a month.  Interest is paid on GICs is periodical as well (it can be anywhere from monthly, to quarterly, to annually or at maturity).  You can also receive interest payments for lending your money to a company or government with a bond.

Dividends are payments that a company gives to its shareholders, sharing company profits with its investors.  Though every company is different, typically companies will pay out dividends once per quarter.

Capital Gains are realized when an investor sells shares for more than they had originally paid for them.  The opposite, when an investor sells shares for less than their initial investment, is called a capital loss.  Share prices tend to increase when there is a corresponding growth in the companies profits, and conversely, a reduction in profitability will often lead to a drop in share prices.  While interest and dividends can provide regular cash flow for your portfolio, portfolio growth through capital gains is unrealized (you won’t receive an increase or decrease in the cash balance of your account) until you close your position by selling your shares. Continue reading Investing Quick Reference Guide