What is better, active management or passive investing? Those in the financial industry will debate this as ferociously as most arguments involving politics and religion. Active management implies owning mutual funds, while passive investing refers to owning an index fund or an ETF. Much of the research I’ve done has led me in the direction of passive over active management; I’ll scratch the surface of why in this blog. Here’s where I land on the spectrum, and it can shift slightly in either direction.
Active management is like renting a luxury vehicle to drive cross-country. The car will have some cool bells and whistles, and you may turn some heads, but the trade-off is you’ll likely pay more than if you rented the economy compact car. The economy compact car will have no bells and whistles, no one will look twice at your Chevy Spark, but you’re renting it because it’s the low-cost way of getting you from point A to point B.
Both cars will get you to your final destination baring any accidents along the way. The same can be said with active and passive investing. When you’re evaluating the rental cars, you know what you’re paying for – heated leather seats vs. unheated fabric seats, a navigation system vs. a standard radio, electric windows vs. manual windows, and comfort over price. This is where active vs. passive deviates from your rental experience.
Knowing what you are getting in a mutual fund can get quite murky. For example, I looked up a well known mutual fund. The fund’s stated objective is to seek capital appreciation by employing a growth-at-a-reasonable-price strategy in seeking well-run businesses poised for growth. Pretty sweet industry jargon there.
The fund’s fact sheet shows me the top 10 holdings and states, “the portfolio is actively managed, and current holdings may be different.” The upside to this statement is that the fund’s benchmark has 1000 individual companies in it. This mutual fund has 72. Theoretically, the portfolio managers picked the 72 positions they believe were best suited to achieve their objective and can pivot as market conditions change to achieve their fund’s objective. The data below shows how difficult that can be over the long-term.
U.S Equity Funds – 15-Year Performance
International Equity Funds – 15-Year Performance
Fixed Income – 15-Year Performance
While this information is telling, I’m not willing to die on the passive investing only hill. I do believe there is a place in portfolios for mutual funds. As I combed through the data, a few noteworthy points jumped out to me. The first is how difficult it is for mutual fund managers to beat their index consistently. The second is that only three groups in the nineteen listed above beat their benchmark in the 1-, 3- and 5-year metrics. The chart below shows those three groups and the percentage of mutual funds in that space that beat their benchmark.
Once you look beyond the 5-year window, there isn’t one of the nineteen that had greater than 50% of the mutual funds, in any category, beating the benchmark. To be fair to the mutual fund industry, you don’t just own mutual funds to try and outperform the ‘market.’ Diversification, downside protection, and active professional management are only a few reasons why someone would want to own mutual funds. The key takeaway is that it’s hard to beat the index, and even harder to beat it consistently. Throw in the added costs and tax inefficiency inherent in most mutual funds, and it’s clear to see why I lean left on the active/passive spectrum.