Active or passive style investing - which is right for you?

Most people have experienced this in one way or another: Two cars driving down a highway – one, a sleek, black sports car racing in and out of the lanes to get out in front of the slower traffic; the other, a white, lumbering sedan keeps to the right lane traveling at the speed limit. Just up the highway, flashing red lights and bells signal a coming train. The black sports car makes a last ditch attempt to beat the train crossing arms but it has to screech to stop. A few seconds later, the white sedan pulls up next to it.

In the world of investing, the driver of the sports car depicts an active investor, while the sedan would match the style of a passive investor. In the investment world, the boring but steady passive investor often outperforms the sexier, more exciting active investor but with less risk and less wear and tear. For investors, it is a question of whether they see themselves as the zigzagging sports car (active style) or the steady and reliable sedan (passive style). Here’s how to tell which might be right for you.

 

What drives passive style investing

Passive investors fully ascribe to the Efficient Market Hypothesis (EMF) that says market prices fully reflect all the information available to investors, which means stock prices are always fairly priced. Any attempt to identify mispriced stocks based on available information will usually fail because, according to the EMH, the movement of stock prices is generally random, driven by unexpected events. The academic evidence behind the EMH concludes that active management of stocks cannot consistently add enough value to outperform the stock indexes and investors are better off investing in a diversified portfolio of low-cost index funds or exchange-traded funds (ETFs).

 

What drives active style investing

Active investors are convinced that there are enough inefficiencies or mispricing in the market that, through in depth quantitative and qualitative analysis, can be exploited for above average returns. They attempt to use their “edge” to drive between the lanes of the market, buying and selling stocks, to get out in front of slower investors. Active managers are expected to outperform their benchmark indexes, which is why investors pay them higher fees.

 

How much is that car costing you to drive?

The issue for active investors is whether they are receiving the added-value in exchange for fees that are as much four times higher than passively managed funds. According to Morningstar, the average expense ratio for a passively managed fund – index fund or ETF – is just below 0.20% while the average expense ratio for an actively managed fund is just above 0.75%. The lowest expense ratio for an index fund is .08% while the highest expense ratio for an actively managed mutual fund is over 2.5%. Yet, another study by Morningstar found that, in the past five years, 75% of U.S. Large Cap funds, 90% of U.S. Mid Cap funds and 83% of Small Cap funds failed beat their benchmark indexes. Of the 450 U.S. Large Cap funds that have existed since 1995, less than a third have delivered market-beating returns.

 

Which style is right for you?

In deciding which investing style is right for you, it comes down to how you see yourself – the driver of a sleek black sports car who is thinks he can get ahead by beating an oncoming train; or, the driver of the white sedan, who puts less stress, wear and tear on his vehicle, with better odds of arriving on time.

 

Source: Morningstar
Vitali Butbaev