Vanguard founder Jack Bogle introduced the Vanguard 500 fund in 1976. He based the fund on the philosophy that average investors would have a difficult time beating the market so they should simply aim to passively match the market’s returns. It was the very first index fund marketed to retail investors.
The index fund was initially mocked by the investment industry as it raised just $11 million in its first year. But what was then known as “Bogle’s folly” has now become the default way to invest for millions of people. Indeed, the Vanguard 500 fund now boasts total net assets of $658 billion (as of February 28, 2021). Who’s laughing now?
Despite this success, and the relatively dismal performance of active investing strategies, investors continue to debate the merits of active vs. passive investing. This article will explain the differences between the two investment styles along with the pros and cons. We’ll also declare an undisputed winner.
Active investing is exactly what it sounds like: an investor (or more likely a fund manager) takes an active role in making investment decisions such as which stocks to buy, which ones to avoid, and when to buy and sell.
The goal of an active fund manager is to beat a benchmark index, often referred to as “the market.” For example, an active mutual fund manager investing in Canadian stocks would likely aim to beat the TSX/S&P Composite Index, the benchmark Canadian index representing about 250 of the largest companies in Canada.
Similarly, an individual investor who invests primarily in Canadian stocks should also compare his or her results against a benchmark like the TSX/S&P Composite Index to see if their “active” investing strategies are adding value and beating the market.
The case for active investing goes something like this: smart fund managers can analyze stock prices and market conditions better than average investors and therefore can make better, more informed decisions on which stocks to buy, sell, or hold (and when).
The promise of active investing is that a smart fund manager can take advantage of upswings in the market but also be protected from the downswings by rotating away from stocks that fall out of favour. Active investing can be boiled down to stock picking and market timing.
Active investing pros:
- Control – Active investors can choose the stocks they believe in and that meet their criteria for a good investment. They can also exclude companies that don’t stand up to their scrutiny.
- Timing – Active investors can change their approach based on market conditions. That could mean taking profits in an overheated market or doubling down when a stock is value-priced.
- Performance – A small number of active fund managers do have a lengthy track record of strong performance, consistently beating their benchmark for many years.
Active investing cons:
- High fees – Active funds need to pay fund managers for their expertise, in addition to marketing the fund to investors. That makes them much more expensive than passive funds, while making the active fund manager’s job, beating the benchmark after fees, that much harder.
- Persistence – It’s difficult for an active fund to consistently beat their benchmark over time. According to the SPIVA scorecard, which tracks active fund performance, 84% of Canadian equity funds have underperformed their benchmark over the past 10 years. U.S. equity funds have performed even worse, with 95% failing to beat their benchmark index.
- Concentration – The paradox for active funds is that in order to beat the market they must be different than the market. More often than not that leads to highly concentrated (not diverse) portfolios where a few losing picks can derail the entire fund’s performance.
Passive investing is also exactly what it sounds like: instead of actively picking stocks and timing the market, investors passively hold the entire market using an exchange-traded fund (ETF) or index mutual fund.
The goal of a passive investor is not to beat the market but to closely mirror its returns, minus a small fee. For example, a passive index fund tracking the TSX/S&P Composite Index would simply hold all 250 Canadian stocks in that index using the exact weight and proportions used to construct the index (e.g., the largest stocks make up a larger percentage of the holdings).
An individual investor following a passive strategy would build a portfolio of index funds or ETFs that track broad market indexes like the TSX/S&P Composite Index, the S&P 500, and the MSCI World Index.
The case for passive investing is that it’s nearly impossible for investors to identify which stocks will outperform over long periods of time, so it’s best to hold every stock and simply capture the returns of the entire market.
Just as importantly, passive funds cost less than their active counterparts because they don’t need to pay a fund manager to make investment decisions.
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Passive investing pros:
- Low fees – Passive funds charge a fraction of the cost of active funds. A Morningstar study showed that low fees are the best predictor of future returns, where funds with the lowest fees outperform funds with higher fees. Some online brokerages really cut costs to the bone by offering 0% commission to buy and sell stocks.
- Rules-based – Passive funds use a rules-based approach that removes any tactical decision-making over which stocks to hold and when to buy and sell them. This has behavioural advantages for investors, removing intuition and internal biases from investment decisions.
- Diversification – A passive, broad market fund holds every stock in the index rather than a select few. This diversification increases the reliability of investment returns because it does not depend so heavily on a small number of stocks to perform well.
Passive investing cons:
- Market returns – By definition, a passive investor will never beat the market and in fact will always trail the market after fees. While this is the entire point of investing passively, some investors will always prefer the small chance of outperforming with an active strategy.
- Lack of control – Passive investors accept market returns and have to go along for the ride no matter how bumpy things get. When markets fall hard, like they did in March 2020, passive investors saw their portfolios fall in-step with the market (of course, this is why a diversified portfolio also contains bonds so investors can rebalance).
- Tracking error – A passive fund is measured by how well it tracks its benchmark index. A poorly managed passive fund will have a higher tracking error (the difference between the fund’s returns and its benchmark index returns).
What does the research say about active vs. passive investing?
Arguably the best evidence that passive investing beats active investing shows up in the previously discussed SPIVA scorecard. Published biannually for the past 15 years, SPIVA clearly demonstrates how difficult it is for active managers to beat a passive index benchmark.
Indeed, in every fund category from broad market equities to dividend and income-focused equities, the vast majority of active funds lagged behind their respective benchmarks.
While active management tells a strong narrative about a skilled fund manager’s ability to pick winning stocks and steer a portfolio away from trouble, the actual results tell a different story. Even though U.S. stocks have offered the best returns over the past decade, 95% of active funds trailed the S&P 500 by an average of 4.1% per year.
Another troubling aspect of active management is the inconsistency of performance. The previous year’s winning funds tend to attract more fund flows (new investors) but then they fail to beat their benchmark in subsequent years, a concept known as mean reversion. Consistency is a huge issue for active managers: 54% of all funds that were in the eligible universe 10 years ago have since been liquidated or merged.
Overwhelming academic and empirical evidence shows us that holding a low-cost portfolio of passive investments is most likely to lead to the best outcome over time.
Passive vs. active investing FAQs
The Final Word: What is the Winning Index Investing Strategy?
There will always be active investors looking for an edge, and that’s okay. Markets need active investors to set prices – that’s the idea behind the efficient market hypothesis and the collective wisdom of crowds. But passive investing is a more reliable and less costly way to capture market returns and meet your investing goals. Plus, it’s never been easier to learn how to buy stock and take a passive investing approach, thanks to robo advisors and online brokerages.