Financial Planning

Active vs. Passive: The Case for Both and a Place for Both

Under certain market conditions, and when it comes to particular asset classes, one method tends to outperform the other. Here's a look at why and what it means to the average investor.

Vanguard founder Jack Bogle started the debate of active versus passive investing when he created the first index fund in 1975. Hundreds of additional index funds, countless studies, and one historic recession later, passive investing has become a household concept and is accepted as the preferred method of investing for millions of investors.

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The Psychology of the Stock Market and Investment Decisions

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You’ve seen the headlines and stats by now:

Billions of dollars are flowing from active to passive funds.

Ninety percent of active stock managers fail to beat their benchmarks.

If you’ve been following this debate for years as I have, you’ve also probably seen the counterarguments, of which there are many.

This is the wrong discussion. The reality is, when it comes to managing investments, there’s room for both philosophies.

Diplomatic, I know.

First of all, when we talk about active versus passive investing, we’re really having two separate discussions. The first is asset allocation, the second is what you do within that allocation. Here’s how I think about each.

Managing Your Allocation

There are several internal factors that dictate how you allocate your portfolio. The evolution of these variables (age, net worth, risk profile, etc.) over time will also change where you fall on the active-passive spectrum.

For many investors, the best solution very well might be robo-advisers. If you have a smaller net worth or don’t require much financial planning, the diversified investment options provided by robo-advisers is as cost-efficient and passive as you’re going to get.

A higher net worth individual, on the other hand, is likely to have more needs. Optimizing a portfolio for complexities like estate planning and tax efficiency will require a more active approach to how assets are allocated. The high net worth clients I work with typically require a more diversified allocation beyond stocks, bonds and cash into assets such as real estate, insurance, private equity and other alternatives.

And then, of course, you have to consider the external factors (i.e., market conditions) when thinking about an active versus passive approach. Historically, active strategies tend to perform better in down markets while passive strategies outperform in up markets. Morgan Stanley found that over the last 20 years, the top 25% of portfolio managers significantly outperformed their benchmarks in years when the market was down.

The period from 2009-today has been one of the longest U.S. equity bull markets in history — save for a couple of brief pauses — so it’s no surprise that passive investing has become the predominant philosophy over the last decade. If the volatility in U.S. equities continues in 2019, it would stand to reason that money would flow back into actively managed funds as investors try to improve their risk-adjusted returns.

Drilling Down

Let’s get to the second part of the equation — determining how active or passive you want to be in managing your specific allocations to various assets. This largely comes down to the asset in question.

Research suggests that active managers are more likely to outperform their benchmarks on a net-of-fee basis in certain asset classes. This is true in international equities, where the median active fund manager outperforms by over 1.5 percentage points per year. That’s a return well worth the customary fees of active management, and the same holds true in small-cap investing.

But there are some asset classes — such as large-cap equities — where the median manager historically can’t beat the benchmark. Add in fees on top of that, and active management becomes hard to justify.

Active fund manager performances don’t stay constant, either. For example, Bank of America found that nearly half of U.S. large-cap equity fund managers outperformed their benchmarks in 2017, the best rate since 2009. Keeping an eye on these trends — this is one area where advisers can help — can be the determining factor in what kind of approach you take for a specific asset in your portfolio.

The Bottom Line

Investing is not a world of absolutes. Whoever decided one approach to investing is universally better than others was wrong.

I’m a big believer in building a portfolio that takes both active and passive approaches into account. But I’m a bigger believer in the idea that no two investors require the same approach. Every one of the clients I work with has different sets of needs and goals. It’s my job to find that balance.

About the Author

Aaron Hodari, CFP®, CIMA®

Managing Director, Schechter

Aaron Hodari is a managing director at Schechter, a boutique, third-generation wealth advisory and financial services firm located in Birmingham, Mich.

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