Active or Passive Investment Management
There is an ongoing debate in the investment world about the best approach to investing; “active” or “passive.” I mentioned in my blog a few weeks ago that investing should be boring and made the case that very few people can actually beat the market. With all the information out there and the speed that news travels makes it extremely difficult for investment managers to find something of value before others do.
First, let me discuss what “active” and “passive” mean in investing sense. Active management means that there is a portfolio manager or team of managers working to create the best possible return for their respective fund. They will rely on forecasting data, their own research and possibly technical trading. The competition is great as there are over 4,000 mutual funds in the universe. These portfolio managers will spend much time making their decisions on whether they should buy, sell or hold certain stocks or bonds. Since, this takes time the cost of these funds will naturally cost you more then a passive mutual fund. Many mutual fund companies offer active funds like Fidelity, T. Rowe Price, TIAA-CREF, Franklin Templeton, American Funds, etc. In short, these managers are trying to imply a strategy that will fair better than the competition.
I am not a huge fan of the term “passive” because it implies a set it and forget it mentality. I always advocate for people to review their portfolios at least once a year to see if any of the funds need to be rebalanced (an Investment Policy Statement would help here). Passive investment management is one where the fund manager is trying to mimic a benchmark. Not trying to beat it. Advisors who utilize a passive strategy believe that all available information is known and that it is not worth the cost or return to imply a strategy to beat the market. An example is the Vanguard 500 Index Fund, which is made up of stocks that are in the S&P 500. For a small cost (~80% cheaper than most mutual funds) you can purchase one fund that has the diversification of the S&P 500. There are many index funds out there that provide diversification at a low cost.
I want to share a few slides to help explain the difficulty for investment managers to beat the market. The data was pulled from the S&P Indices Versus Active (SPIVA®) which measures the performance of actively managed funds against their relevant S&P index benchmarks. The nice folks at Dimensional Funds Advisors have given me permission to share these slides. Let’s dive in!
Over the last 5 years ending in 2012 most active mutual fund managers failed to beat their benchmark in their respective asset class category. That means that 75% of U.S. large cap managers failed to beat the S&P 500 over a 5 year span.
Now let’s take a look at the overall performance from 1, 5 & 10 years. After the first year only about 37% of managers beat their benchmark and as you can see the percentage starts to dwindle down the longer the track history. What this is also showing is the survival rate of mutual funds. If a fund is performing poorly many of the mutual fund companies will close the fund or merge it with another fund. So if you picked a mutual fund 10 years ago there was 49% chance that it is no longer available!
The data also illustrates the difficulty of long term performance. Only 17% of active managers outperformed their benchmark in a 10 year span.
You may be asking yourself, well what about picking a manager who has performed well in the past, they have the right stuff to continue, right? Well actually, this is not necessarily the case. Over 3, 5, & 7 year periods many of these mutual fund managers failed to continue their stellar performance.