One of the most heated (and therefore potentially confusing) topics in investing is whether to be active (try to choose winners) or passive (just “go with the flow”). In this post we’ll see that one reason for the confusion is that “active versus passive” really encompasses many different questions.
It’s all very well making plans, whether they’re made by you or by your financial professional. But the rubber has to hit the road. You have to invest the money. And that’s when you get hit by the most expensive issue you’ll face: whether to invest actively or passively. And perhaps the ultimate irony is that you might never face the issue directly, but instead default into active management. Let me explain what this is all about. And I’ll do so by identifying three entirely separate issues that are often confused by being placed under the same heading of “active versus passive.”
Here’s how I’ll do it. First I’ll define active and passive, in case you haven’t come across the terms before, or are less than totally familiar with them. Then I’ll identify the three separate issues. My goal is that, by the end of this post, you’ll see that they really are separate issues. And then, in the next three posts, I’ll discuss each of the issues separately. By the end of this mini-tour, you should be pretty clear as to how you’re going to deal with each of the three issues.
OK, definitions first.
Passive management means, in effect, buying all the available securities of a particular type in an investment market. Typically this becomes feasible when there’s an index compiled that reflects most of the investible securities of that type. Examples are the Russell 3000® Index for US equities and the FTSE All-Share Index in the UK. You then buy the index, typically through a mutual fund or unit trust or exchange-traded fund (ETF) that attempts to match the composition of the index. The index itself is typically compiled and periodically updated to reflect the available securities of the kind (typically the asset class) being considered. The goal of passive investing is to find a convenient way to enjoy the returns of everything in the index. Since the index is compiled according to specific rules, matching its composition is usually an easy investment exercise and therefore relatively inexpensive.
Active management means investing in the same asset class, but with the goal of achieving a higher return than the index, by selecting those securities thought to have a higher likelihood of beating the average that the index represents. In other words, get a higher return in good times, and don’t do as badly in bad times. This requires a great deal of research in comparing all the securities available to choose from, and opinions change as time evolves, so trading (selling some securities and buying others) becomes necessary. The cost of research makes the fees charged for active management much higher than for passive management, and the cost of trading systematically reduces returns; so the barrier to winning in the active management game is high. So can the rewards be, of course – as well as the cost of failure to win.
Sometimes active management extends further, in trying to determine which of several asset classes are likely to do better than others in the short or medium term (by which I mean the next few months or the next few years, rather than over your entire investment horizon), and trading appropriately across asset classes. This used to be called “market timing” until that phrase developed a bad reputation, after which it got called “tactical asset allocation” or something along those lines.
That’s the background.
When you go to an investment professional, sometimes there isn’t much discussion of the issue, and you may be defaulted into one or more funds that are actively managed. It’s always true that active management involves higher fees than passive management; but you may not see the fees explicitly, so you may not realize what you’re paying. It used to be (and may still be, depending on which country you live in) that financial professionals were paid more (by the sponsors of the funds) for placing you in active funds than in passive funds – potentially a conflict of interests, even when the professional sincerely believed that he or she was skillful in being active or in selecting skillfully managed active funds, and so you would benefit from this skill. Clearly, you should have a choice, and it’s best if that’s an informed choice.
Now let me identify the three separate issues involved here.
- Fees: Make sure that you are aware of all the fees you’re paying, directly or indirectly. This is quite separate from whether you’re successful or not with active management. The fact is that fees are certain; success isn’t.
- Skill: Everyone who is involved in active management genuinely professes skill in being active. The thing is, skill here doesn’t just mean getting a good return (passive management can also get a high return); skill means getting a better result than the average of others who also profess the same skill. So it’s not just their skill you’re relying on, it’s also your own skill in finding them. Is there such skill? If so, how do you locate it? And if so, under what circumstances should you pay more for it? The fact is that many studies find that fees and skill aren’t correlated.
- Broaden the discussion framework: Typically the issue is discussed as if there’s a right answer and a wrong answer, and it’s your job to find the right answer. That’s unfortunate. The fact is that often it’s best to be partially passive and partially (sometimes necessarily) active. And you ought to understand when each of those choices is most appropriate for you.
In short, if you understand this framework and the discussion of the issues in the next three posts, you’ll be able to make the choices that best fit your own situation.
Whether to be an active or a passive investor is a discussion that typically confuses three separate questions: how much you pay, what you’re paying for, and whether the choice should be “active and passive” rather than “active or passive.”
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.