The debate between active and passive investing is one of the most important within the investment community, hence a comparison is necessary. In this post we will analyze both investment styles so that you can determine which one is best for you.
- Philosophy: difference between Active and Passive investing
- Myths about Active investing
Philosophy: difference between active and passive investing
Active investing aims to achieve higher returns than those of the market in general and for that is willing to take on more risk. Passive investing simply aims to achieve the returns of the general market but with lower costs. Those lower costs can have the effect of boosting net investor returns.
Let use an example to understand it. The main companies in the United States are part of the S&P 500 stock market index. The S&P 500 includes the 500 largest companies in the country.
The S&P 500 index is the most representative of the US stock market. Hence, if we want to invest in US stocks, our two main options are to invest actively or passively.
If we want to try to outperform the returns of the S&P 500, we will opt for active investing. This means putting our money in a fund that tries to beat the S&P 500 by picking individual stocks, or investing ourselves in the companies we deem to have the most potential.
Although investing ourselves is a form of active investing, the debate between active and passive investing usually refers to the choice we have to go for active or passive investment funds.
On the other hand, if we simply want to achieve a level of return in line with that of the US stock market, we will go for passive investing. In that case we will simply invest in an S&P 500 ETF or index fund.
It may seem tempting to choose active investing without a second thought, as it offers us the potential to achieve higher returns. However, it has its drawbacks and risks, and we will analyze those in the sections below.
Let us now discuss the most important differences between active and passive investing.
One of the biggest selling points for passive investing is its low costs. Many developed market ETFs have annual management fees of as little as 0.1% or even lower. ETFs that track slightly more exotic markets, such as emerging countries, have management fees in the range of 0.2-0.5%.
On the contrary, active funds tend to have much higher fees, usually between 1 and 2% annually on our invested capital, even for developed markets.
As you can see, the difference can be huge, and this only compounds itself for longer investment periods. We will illustrate that with an example:
If we invest $100,000 in an active fund with a management fee of 1.5% and obtain a 6% gross return, our net return will be 4.5%. A year later our investment will have grown to $104,500. If we manage to have that same performance every year for 10 years, we will end up with $155,297.
On the other hand, if we invest those same $100,000 in a passively managed ETF fund with a management fee of 0.1% and obtain the same 6% gross return, our net return will be 5.9%.
After a year our assets will have grown to $105,900, 1.34% higher than with the active fund. 10 years later our investment would have grown to $177,402, 14.2% more than in the active fund. And such a difference continues to grow over time.
This means an active needs to have significantly higher returns just to break even with passive funds. Not all active funds can achieve that. And even then, we would be taking on more risk to end up with the same return.
Most active funds do not have higher returns
Here is they key as to why it is usually not worth to invest in active funds. Although the active management industry will often try to sell us their funds with the potential and promise to outperform the market, reality looks a lot different for most of them. And this can be explained mathematically:
If the market has had a return of 6%, that means that the average gross return for all investors, whether active or passive, is 6%. That is exactly what the overall market tells us.
We know for a fact that the gross return of passive investors will be 6%. Assuming a management fee of 0.1%, their net return will be 6.9%.
The average gross return for active investors will be 6% too. This is mathematically true. However, assuming a management fee of 1.5%, their average net return will only be 4.5%.
We can draw two very important conclusions from that:
The active fund needs least a 7.4% gross return to break even with the passive fund on a net return basis. This is because of its higher fees. And, ultimately, investors care about net investments.
If an active fund manages to outperform the index, this has been at the expense of another active fund, since active management is a zero-sum game. If one fund has achieved a 7.4% gross return (necessary to equal a passive fund on a net basis), there is another fund that will have achieved a 4.6% gross return (3.1% net).
As a whole, passive investors will always end up ahead of active investors, even though a minority of passive investors will end up at the top.
Myth 1: You should only invest in the best active funds
While it is true that there will always be a small minority of active funds that outperform the market considerably, the difficulty lies in identifying them before that happens. And that is not feasible.
There have been numerous studies on this topic, and it has been proven time and again that the results of previous years have no predictive power when it comes to forecasting results for the following year.
Consequently, do not be fooled by statements about pas performance numbers. Statistically speaking, there will always be a minority of funds with better returns than others, but that does not mean they can guarantee those into the future.
Myth 2: Passive funds are riskier because they invest in all companies, even the bad ones
Before analyzing why this statement is a fallacy, it should be noted that it is also irrelevant. We have already discussed in the previous sections that, as a whole, passive funds will always end up with higher net returns than active funds. But since you may hear such a statement in the future, it is worth debunking it.
While it is true that there are stronger companies than others, what determines a good investment is not only the strength of the company.
No one doubts that Coca-Cola is one of the best companies in the world, with an internationally recognized brand and a very solid balance sheet. On the other hand, Tesla is a highly indebted company that has barely generated profits throughout its history. Hence, Tesla is riskier than Coca-Cola.
But that does not mean Coca-Cola is necessarily a better investment, since the price we pay for a stock and its growth potential are very important factors.
In the period between 2011 and 2019, Coca-Cola had a total return of 122%, while Tesla’s was 1,491%. And such comparison does not include what happened from 2020.
As a result, investing in weaker or riskier companies might good or bad. No one can reality tell before the fact. Consequently, avoiding them is no guarantee for an active fund outperforming the market.
Myth 3: Active funds are better in choppy markets
This myth is related to the previous one. It is based on the idea that, if market falls, passive funds will go down, while active funds may be able to minimize losses thanks to the actions their fund managers can take.
Such a statement can be debunked by remembering that, on average, the gross return of all active funds will be the same as that of the market and all passive funds. And while it is true that some active funds may fare better during a down market, that also means other active funds will fare worse than the market.
If the market drops by 30%, all passive funds will lose 30%. Some active funds may drop less than 30% and a few may even achieve positive returns. But other active funds will see gross returns worse than 30%.
Passive investing is generally superior to active investing. As a result, if you are interested in investing in a certain asset class, like European stocks, odds will be in your favor if you opt for a passive investment vehicle.
Although we have focused on the stock market in this post, everything discussed here is also relevant for the government or corporate bond markets, where you can also invest actively or passively.
It should be noted that marketing from active fund managers may be more aggressive. But beware all the myths we have just addressed.
As a last note, I would like to say that there is a lot of value in having a financial advisor help you with your investments. A financial advisor will work with you to determine which markets you should invest in and how much money.
The decision of whether to invest in an active or passive fund will after, once it is time to put the money in the asset classes chosen for you. Passive investing does not mean we take no decisions. It simply means not trying to beat the markets we invest in. But we still have to decide in which markets we will invest.
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