On Passive and Active Investing
The Rise of Index Investing, Characteristics of Passive and Active Investing, and the Ensuing Market Dynamics
John Bogle, the father of index investing, created the first index fund marketed to retail investors in 1976.
Founder of Vanguard and Princeton-alum, Bogle raised $11 million for the Vanguard 500 fund.
As of December 31, 2020, the fund manages $636.9 billion.
Index investing has not only gained in popularity over the last few decades – it has become a cornerstone of the financial markets. From robo-advisors to retirement accounts, index funds are now intrinsic to the financial system and continue gaining traction.
Index investing is estimated to account for nearly 14% of the U.S. stock market in 2019, up from 7% in 2010.
In August 2019, assets in index funds reached $4.27 trillion, surpassing the $4.25 trillion of assets in actively managed funds for the first time. Funds do not represent the whole market; many investors and money managers purchase shares of companies directly.
Passive and active investing are two very distinct approaches to investing, each with strong advocates. Investors should understand the differences for themselves and identify how each approach fits into their personal investment strategy and objectives.
Passive Investing
Index funds, typically ETFs or mutual funds, are designed to track an index. They typically offer low expense ratios, sometimes below 10 basis points. Vanguard’s VOO, for example, seeks to track the S&P 500 and has a management fee of 0.03%.
Investing in an index fund can be attractive because the returns of the vehicle should equal the index’s return (minus the minimal management fees). It is comforting to know that the fund should track the benchmark closely.
Passive investing, distinct from index investing, is an investment strategy seeking to minimize transaction activity, in an effort to avoid excess fees and poor performance that can result from frequent trading. Passive investing is often implemented by purchasing and holding index funds for the long-term. In There is often little, if any, investigation into the underlying companies.
The difference between index investing and passive investing is somewhat nuanced.
Consider an investor who is fully invested in index funds. Nervous with the market being at an all-time high, they decide to sell half of their holdings. This investor is actively managing their portfolio in an attempt to time the market. Because they made the choice to sell, they will now have to make a decision on when to buy. The investor may also have incurred a tax liability if there were any gains.
Because of their trading activity, this investor’s returns are unlikely to track the index fund’s returns, much less the underlying benchmark’s.
Active Investing
Active investing is a hands-on investment strategy, wherein an investor actively chooses when and what to invest in. Often investing in companies, active investors typically seek to outperform a relevant benchmark.
There are many different approaches investors may take. Popular forms of research include:
fundamental analysis – analyzing a company’s financial statements over time
technical analysis – analyzing supply and demand indicators in the market such as volume and price movement
qualitative analysis – analyzing strategic positioning and potential value add of a firm
Those can be applied to a myriad of strategies, including, but not limited to:
value – looking for companies that trade below their intrinsic value
growth – looking for companies that are growing quickly and are likely to be worth more in the future
momentum – looking for companies that have been moving in a particular trend
low volatility – looking for companies whose price fluctuates less than the market
sectors – looking for particular sectors or industries with advantages, opportunities, or other characteristics
…
Because active investment requires investigation, fees on actively managed investments tend to be higher than those of passive investment vehicles. Fees may vary from 0.5% to over 2.0% of assets under management. Some private managers may charge a performance fee in addition to the management fee. Hedge funds are known for the 2-and-20 structure, charging 2% of assets under management and a 20% performance fee.
As noted previously, index funds -- and any other fund, for that matter – can be used as a vehicle for active investment. For example, macroeconomic signals and sector-specific trends can be used to form timing and other tactical allocation strategies. Investors should be weary of double fees, which can occur when money managers invest in other funds.
Active investing does not necessarily dictate a holding period. Active investors may hold positions for many years or a few minutes. While day trading is a form of active investing, many active investors may track and hold positions in companies over many years. In contrast to passive investors, active investors would likely follow the company with interest to any new developments or signals as to the future direction of the company.
Active investing does not necessarily seek to outperform the market. Different investors have different objectives. Those objectives may inform the portfolio composition which would be useful in identifying the relevant benchmark. For example, an investor seeking a conservative portfolio, with an 50/50 allocation (50% in equities, 50% in bonds), should not expect to outperform the S&P 500. Rather, the relevant benchmark in that case would be a 50/50 composite index.
In order to create value, an active investor should seek to outperform the relevant benchmark. In the case of an investment manager, they would need to over perform in excess of their fees to generate value.
Assessing the performance of an active investor is non-trivial. As a starting point – past performance is not an indication of future performance. In the case an active investor has outperformed, it is difficult to differentiate two confounding factors: skill and luck. These two traits are not independently observable and can only be understood over time and through statistical analysis, which requires sufficiently large data sets that may not be available.
There has been plenty of research on the topic. Many of them look at the publicly managed funds, ETFs and mutual funds, because the data is readily accessible. Results concluded from these studies are likely representative of the constituents. However, it would be a stretch to extrapolate beyond publicly managed funds because of their inherent characteristics, such as:
they are large funds, burdened by the law of large numbers, which allow for fewer opportunities
seeking to preserve their job, fund managers may be focused on short term result
for the same reason, fund managers may invest conservatively
These publicly accessible funds account for roughly 14% of the U.S. stock market, as noted in the introduction. Combining those with the roughly 14% in index funds leaves at least 72% of assets unaccounted for.
Market Dynamics & Implications
Passive investing relies on index funds. Index funds track a benchmark. Within that benchmark, performance of the underlying assets varies.
Taking it to an extreme, consider what would happen if all funds were passively invested. The relative value of companies would remain unchanged, while the underlying fundamentals would be inevitably changing. In this scenario, a company would maintain its valuation, even as it approached bankruptcy. This would not be sustainable.
An active investor would inevitably step in.
Passive investing does not work without active investors. Index funds require active investors to set the valuation. It could be said that index funds amplify the market activity, giving more voting power to the active investors. It is no surprise that momentum is one of the only technical strategies that has evidence at being predictive.
That being said, active investing is not for everyone. In fact, the average investor underperforms.
Passive investing can be a great, low-cost approach to investing. It does, however, limit the potential upside. To paraphrase Seth Klarman, a famed value investor and author of the Margin of Safety, "index investing is accepting assured mediocracy to forgo the risk of being wrong”.
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Federico Torre
Torre Financial
federico@torrefinancial.com
https://torrefinancial.com
https://torrefinancial.substack.com
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