The active vs. passive investing debate

What's so great about being passive, including in investing?

Charles Ellis, an investor with over 50 years of experience, wrote in the Financial Analysts Journal about the ongoing debate between proponents of active investment strategies and advocates of passive strategies. Whether you are setting asset allocation guidelines or choosing specific investment products, understanding some of the arguments in this debate might be important to your decision making - especially since real-world investment approaches often include elements of both active and passive investing.

In a nutshell, active investors believe that with careful analysis, it is possible to find better-than-average investments. Passive investing advocates make the point that not every investment manager can be above average, and that the higher cost of active management fees results in below-average results overall.

Ellis points out that the distinction is not really that simple. What follows are some perspectives on why active investing can be important and how you can avoid some of the pitfalls common to active investing.

5 reasons for active investing strategies

So why fight it? Wouldn't it be easier just to invest in an index fund and go along for the ride?

Here are five reasons why active management might still be worth considering:

1. Benchmark investing does not serve an investor's true goals

Passive investing typically is designed to mimic the performance of a given market benchmark, but is that really why you are investing? Real-world investors are typically trying to fund some future need, and various benchmarks will serve that goal better at some times than at others.

2. Many active managers are too passive

Ellis makes the argument that the flaw of many active managers is not their active decision-making but that they are too passive. Ellis estimates that in an attempt not to stray to far from the pack, managers devote 60 to 80 percent of their portfolios to mimicking a benchmark, leaving active decisions in a minority of the portfolio with the burden of trying to add enough value to surpass the manager's fees for the entire portfolio.

3. Passive investing involves some active decisions

Sure, you can pick an index fund, but which index? There are dozens of choices, each representing a different market or type of security, so each will have its unique investment characteristics. Therefore, even the choice of passive investments requires active decision making.

4. Active analysis encourages market efficiency

Another point Ellis makes is that active managers essentially keep companies honest by directing money towards successful ones and away from unsuccessful ones. Passive investing removes that accountability by investing in a company simply because it is in a market index.

5. Consumer behavior is part of the problem

In many cases, the failure of active investing is the fault of consumers rather than the managers because consumers tend to make too many short-term moves from one fund or manager to another in an attempt to chase hot performance.

5 ways to avoid active investing mistakes

The above points mean that to some extent, active investing has gotten a bum rap. However, some criticisms of it are legitimate and if you choose an active approach, you had better do so in a way that acknowledges the pitfalls so you can attempt to avoid them.

1. Keep fees reasonable

Fees for active management are higher than for index funds and the like. If you pay more than 1 percent, you are really creating a high obstacle to overcome.

2. Distinguish luck from skill

Any manager can get hot over a short period of time. Don't be too impressed with short-term performance numbers. Instead, look for success over full market cycles.

3. Distinguish style from skill

If a manager has a given style bias (e.g. value, growth, small-cap, etc.) check performance index specific to that style. Make sure a good run of performance was not attributable more to a given style having a strong period than the manager's individual decisions.

4. Watch for organizational changes

If a manager has done well for you, keep abreast of changes in key personnel that could jeopardize the ability to continue that success.

5. Be aware of the impact of size

As successful managers attract more business, they often find it tougher to continue to execute their strategies with more assets under management, especially if their success was based on small-cap stocks or relatively illiquid securities.

Even the most die-hard passive investing advocate has to make active decisions: about asset allocation policy, which index fund to choose, how to handle inflows of cash and where to turn for liquidity. Since every investment approach has some active elements, it is better to try to understand active investing rather than summarily rejecting it.

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