A Comparison of Active and Passive Investment Strategies
WHAT IS ACTIVE MANAGEMENT?
Active management might best be described as an attempt to apply human intelligence to find "good deals" in the financial markets. Active management is the predominant model for investment strategy today. Active managers try to pick attractive stocks, bonds, mutual funds, time when to move into or out of markets or market sectors, and place leveraged bets on the future direction of securities and markets with options, futures, and other derivatives. Their objective is to make a profit, and, often without intention, to do better than they would have done if they simply accepted average market returns. In pursuing their objectives, active managers search out information they believe to be valuable, and often develop complex or proprietary selection and trading systems. Active management encompasses hundreds of methods, and includes fundamental analysis, technical analysis, and macroeconomic analysis, all having in common an attempt to determine profitable future investment trends.
WHAT IS PASSIVE MANAGEMENT?
Passive investment management makes no attempt to distinguish attractive from unattractive securities, or forecast securities prices, or time markets and market sectors. Passive managers invest in broad sectors of the market, called asset classes or indexes, and, like active investors, want to make a profit, but accept the average returns various asset classes produce. Passive investors make little or no use of the information active investors seek out. Instead, they allocate assets based upon empirical research delineating probable asset class risks and returns, diversify widely within and across asset classes, and maintain allocations long-term through periodic rebalancing of asset classes.
WHAT IS INDEX INVESTING?
Index investing is a form of passive investing in which portfolios are based upon securities indexes which sample various market sectors and are constructed by committee. Best known is the Dow Jones Industrial index, a basket of thirty very large U.S. companies. Indexes are available for most domestic and international markets, and rise and fall as individual securities within the index rise and fall.
WHICH WORKS BEST?
Research supporting passive management comes from the nation's universities and privately funded research centers, not from Wall Street firms, powerful banks, insurance companies, active managers, and other groups with a vested interest in the huge profits available from active management. The results from this research are very clear: Active investment management is an appealing mirage which substantially boosts costs and decreases returns compared to properly designed passive portfolios. Research employed in the development of passive and index investment strategy has shown that:
MARKETS AND ECONOMIES ARE UNPREDICTABLE.
Given that there are thousands of stock market experts, mutual fund managers, private money managers, and advisors, some will make spectacular calls and accurate predictions. Yet, extensive research has shown that, as a group, the performance of experts is what would be expected from chance guessing, there is no way of knowing in advance who will make the right call, and past success is unrelated to future performance. For example, studies have found that past earnings growth for companies is only weakly correlated with future earnings growth or stock prices. Never-the-less, active managers and investors excitedly watch earnings reports for clues to the future price of a stock.
Economists in both the public and private sector provide a continuous series of data and forecasts in an attempt to predict future economic and investment trends. Yet, numerous studies have found that economists cannot predict major turning points in the economy, forecasting skill is, on average, about as good as chance guessing, and economic data is of poor quality and subject to frequent major revisions. For example, one study found that Federal Reserve economists did significantly worse than chance in predicting economic growth and turning points in inflation from 1980 through 1995.
FUTURE SECURITIES PRICES ARE UNPREDICTABLE.
Several statistical studies have found that the price behavior of securities, such as stocks, bonds and commodities, is indistinguishable from that of random numbers. Patterns in numbers occur, technicians attribute great signficance to them, but they have no demonstrated persistence or predictive power. Over many decades, the prices of securities trend upward due to inflation and economic growth. Otherwise, future securities prices are unpredictable. However, selling predictions is a big and profitable business.
RISK AND RETURN ARE ABSOLUTELY CORRELATED.
High potential returns always involve high potential risks. There are no low-risk/high-return investments. Investment risk comes in many forms but, to most investors, risk means the potential for losing investment capital and the duration or permanency of that loss. Through analyzing the best available long-term data, researchers have carefully defined the risk/return ratios of all major asset classes and identified the correlation or interdependence of different types of investments. These findings provide our best approximation of future risk and return for any given asset class or mix of asset classes, and clearly show that there are no high return, low risk asset classes.
ACTIVE MANAGEMENT IS MUCH MORE EXPENSIVE THAN PASSIVE MANAGEMENT.
Active investors must overcome many costs to match the returns of the average passively managed portfolio. These include trading costs, much higher management fees, market impact costs as active managers affect the prices they pay, dilution from maintaining higher cash positions than passive managers, taxes in taxable accounts due to high turnover rates, and, commissions, if an investment "product", like a mutual fund, is purchased through a broker or financial salesperson. These costs create a handicap for the active investor of 2.5% to 9% per year, depending upon asset class mix, and whether a salesperson is involved. The least expensive forms of active management, no-load mutual funds and "wrap fee" accounts, typically consume 2.5% per year from investor's returns, while the average passive or index portfolio costs under 0.5% per year.
ACTIVE MANAGEMENT IS MORE RISKY THAN PASSIVE MANAGEMENT.
Active managers attempt to choose securities which will outperform the market and, therefore, concentrate their "bets" across relatively few securities. If an active manager bets wrong, they may very significantly underperform market averages. Passively constructed portfolios, however, are highly diversified and contain thousands of securities allocated amongst various investment categories which have been identified by research and have predictable and quantifiable risks and returns. Further, research has shown that diversification itself produces higher returns with lower risks than simply investing in one or two investment categories.
ACTIVE MANAGEMENT UNDERPERFORMS PASSIVE MANAGEMENT.
Because of increased costs and risks, about 75% of active managers, as a group, underperform passive portfolios during any given year and, over time, this percentage increases until only a few outperform market averages. When matched for asset type and mix, passive managers outperform active managers by about 2% per year, on average. In addition, active management in taxable accounts creates a constant stream of capital gains taxes which must be paid each year. Studies show that after-tax returns in active accounts are 30% lower, or more, over long investment time-frames.
INVESTORS EMPLOYING ACTIVE MANAGEMENT DO FAR WORSE THAN THE ADVERTISED NUMBERS, AND WOULD DO BETTER BUYING C.D.'S AT A BANK.
Studies of the real returns achieved by investors are hard to find. Two studies covering ten to fifteen year time frames have found that broker advised investors, and investors self-managing their accounts, captured only one-quarter or less of the total returns produced by indexes and less than half the return reported by managers and mutual funds. This is due to the tendency of brokers and investors to move around too rapidly, ultimately picking a losing asset class. Another study pitted five prominent advisors specializing in mutual fund selection against the S & P 500, a widely used market and index benchmark. The best advisor lagged the S & P by about 40% for the six years from 1993 through 1997. A study done by DALBAR, a respected independent financial markets research group, found that the average equity investor earned annual returns of only 2.6% for the seventeen year period from 1984-2002, less than inflation at 3.1%. The S & P 500 index averaged 12.2% per year, and one month C.D.'s returned 5.8%, over twice what the average equity investor received. An update of the study at the end of 2004 found that average investor earned annualized returns of 3.5% versus 4.87% annualized for a one-year fixed index with minimal volatility. A further update covering 1986-2006 found that the S & P 500 returned 12% annually while the averaged investor received 4% and the average market timer, -2%. These studies are, of course, never mentioned by the mainstream financial press or Wall Street brokerages; it would be bad for business. Retail investors aren't likely to do well following Morningstar, CNBC, or other sources for selecting mutual funds.
Individual investors actively trading their own accounts don't seem to do very well either. Data from the Japanese stock market from 1975 through 1997, across bull and bear markets, show that stocks with high individual ownership gained an average of 7.13% per year while stocks with high institutional ownership averaged 15.25% per year. Stocks that saw the biggest increases in individual ownership in a given year fell by 5.2% during the 12 months of purchasing, while stocks that saw heavy individual selling posted an average return of 44.3%. The thundering herd of individual investors is usually wrong.
"EXCEPTIONAL" ACTIVE MANAGERS CANNOT BE IDENTIFIED IN ADVANCE.
A tiny handful of superstar money managers with outstanding past performance are constantly promoted by the media as evidence for the benefits of active management. Yet, no one knew in advance who would outperform, the odds of selecting one are low, and the results they achieved may be due to luck. Hundreds of carefully done studies have found that past performance of money managers, mutual fund managers, investment analysts, and others is unrelated to their future performance. Track records mean nothing. The two greatest superstar active managers of our time, Warren Buffet and Peter Lynch, both recommend index funds.
ASSET CLASS MIX IS THE MOST IMPORTANT DETERMINANT OF INVESTMENT RETURNS.
An asset class is a group of securities which have similar risk and return characteristics. One year Treasury bonds, or commercial real estate, or small company U.S. growth stocks, or emerging market stocks, are examples of asset classes. Research has clearly established that performance differences between different professional money managers are due predominantly (90%, or more) to the asset class they choose. Markets, not managers, produce returns.
THE "SMART" MONEY USES PASSIVE INVESTMENT STRATEGIES.
An estimated 40% to 50% of all institutional monies are in index or passive portfolios while only 3% to 4% of retail investors make use of passive strategies. Passive strategies are employed by AT&T, CALPERS, IBM, Intel, K-Mart, PacTel, Pepsi, and Stanford University, among many others.
REFERENCES:
Bernstein, William. The Intelligent Asset Allocator, McGraw-Hill, 2001. A detailed look at asset allocation in passive and index portfolios. It may be advanced for readers uncomfortable with statistics.
Clyatt, Bob Work Less, Live More, Nolo, 2005 A clear written and practical look at "early semi-retirement". This book is about half lifestyle planning and has an introduction to prudent passive and index investing.
Bogle, John Common Sense on Mutual Funds, Wiley, 1999. A thorough examination of research on passive and index investing and the disadvantages of active management from the founder of Vanguard mutual funds and the first retail S & P 500 index fund.
Sherden, William A. The Fortune Sellers. Wiley, 1998. An amusing and revealing expose of the failure of experts in many fields, including investing, to add value over chance guessing.
Swedroe, Larry E. Winning Investment Strategy. Dutton, 1998 and What Wall Street Doesn't Want You To Know, 2000, St. Martin's. Both these books are easy to read and informative introductions to passive and index investing and DFA/University of Chicago allocations models.
Taleb, Nassim The Black Swan, Random House, 2007. A critical examination of the the statistical models underpinning modern finance and their limits.
