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Active vs. Passive Investing: Step Back for Better Returns

Passive investing tends to be quicker and easier, and deliver better overall returns
Sept. 29, 2017
Investing, Investing Strategy
active vs passive investing
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The news has been the same for years: More money is flowing out of actively managed investment funds and into passively managed funds.

In 2016, investors pulled $285 billion out of active funds, while pushing nearly $429 billion into passive ones — and this year is seeing a similar shift, according to Morningstar. Deutsche Bank estimates passive funds will have as much total money as active ones within a few years.

So why are investors so gaga over going passive?

The short answer: A passive approach leads to better overall returns, and it’s quicker and easier than researching and picking stocks. Here’s why passive investing may work for you, and how you can start investing passively with a robo-advisor without having to know much about the stock market.

Difference between active and passive

There are two broad approaches to investing: active and passive.

  • Active investors research and follow companies closely, and buy and sell stocks based on their view of the future. This is a typical approach for professionals or those who can devote a lot of time to research and trading.
  • Passive investors buy a basket of stocks, and buy more or less regularly, regardless of how the market is faring. This approach requires a long-term mindset that disregards the market’s daily fluctuations.

Similarly, mutual funds and exchange-traded funds can take an active or passive approach.

  • Active fund managers are buying and selling every day based on their research, trying to ferret out stocks that can beat the market averages
  • In contrast, passive fund managers are content to be the market average, hitching themselves to a preset index of investments, such as the Standard & Poor’s 500 index of large companies or others

And investors can mix and match. They can be active traders of passive funds, betting on the rise and fall of the market, rather than buying and holding like a true passive investor. Conversely, passive investors can hold actively managed funds, expecting that a good money manager can beat the market.

» Prefer the passive approach? See our picks for top robo-advisors 

Passive investing tends to deliver

About 83% to 95% of active money managers fail to beat their benchmark’s returns in any given year; they bet against the Dow Jones industrial average, and the Dow won. With so many pros swinging and missing, many individual investors have concluded that “if you can’t beat ‘em, join ‘em.” They’ve increasingly opted for passive investment funds made up of a preset index of stocks or other securities.

Passive funds buy and sell stocks mechanically. Investors in passive funds are paying for computer and software to move money, rather than a high-priced professional. So passive funds typically have lower expense ratios, or the annual cost to own a piece of the fund. Those lower costs are another factor in the better returns for passive investors.

Funds built on the S&P 500 index, which mostly tracks the largest American companies, are among the most popular passive investments. If they buy and hold, investors will earn close to the market’s long-term average return — about 10% annually — meaning they’ll beat nearly all professional investors with little effort and lower cost. An active fund manager’s experience can translate into higher returns, but passive investing, even by novice investors, consistently beats all but the top players.

That hardly sounds like “settling” for a passive approach. In fact, billionaire investor Warren Buffett recommends buying low-cost S&P 500 index funds regularly as the best option for regular investors.

While S&P 500 index funds are the most popular, index funds can be constructed around many categories. For example, there are indexes composed of medium-sized and small companies. Other funds are categorized by industry, geography and almost any other popular niche, such as socially responsible companies or “green” companies.

While some passive investors like to pick funds themselves, many choose automated robo-advisors to build and manage their portfolios. These online advisors typically use low-cost ETFs to keep expenses down, and they make investing as easy as transferring money to your robo-advisor account.

» Want active investment management? Look at our top brokers for mutual fund investors

But you have to stay put

To get the market’s long-term return, however, passive investors have to actually stay passive and hold their positions (and ideally adding more money to their portfolios at regular intervals).

For most investors, the first step toward being active can mean taking a bite out of their potential returns. Investors are tempted to:

  • Sell after their investments have gone down in value
  • Buy after their investments have gone up in value
  • Stop buying funds after the market has declined

Even active fund managers whose job is to outperform the market rarely do. It’s unlikely that an amateur investor, with fewer resources and less time, will do better.

In the chart above, you can see how a passive S&P 500 indexing approach compares with the performance of all stock funds (both active and passive) during various periods over the past 30 years, as measured by Dalbar, an independent evaluator of financial performance. A passive approach using an S&P index fund does better on average than an active approach.

To read a short case study on how active investors followed Peter Lynch, one of the world’s top investors, and still lost money, click below on the sidebar.

+ Want an example?

Peter Lynch ran Fidelity’s Magellan fund for 13 years, from 1977 to 1990. As an active fund manager he racked up an impressive 29% annual return – about double the market’s 13.3% during that period. That would have turned an initial $1,000 investment into more than $27,000 at the end of Lynch’s tenure.

Active investing can work for some investors and lead to outsized gains. And some money managers are adept enough that they can pretty consistently, though not always, beat the market averages. Even investing legends such as Warren Buffett stumble sometimes, although Buffett’s long-term track record is phenomenal.

What about investors who actively traded Lynch’s fund? They fared horribly, at least relative to the asset manager. Lynch’s investors in total earned only 7% annual returns, and the average investor actually lost money, Fidelity figured, as they chased his hot performance, buying after stocks had run up and selling after they had fallen. Lynch was a best-case setup for active investors, and they failed miserably.

Investors paid in other ways. They paid commissions to trade the fund, and were liable for any taxable gains. Investors also bore the time cost of monitoring the portfolio and worrying about when to sell. Active funds tend to have a higher expense ratio than passive funds, too.

And passively investing in an active fund?

Passive investors, however, fared fabulously in Lynch’s fund.

They would have performed about as well as Lynch himself, 29% annually, and some would have done better, depending on when they had added money to their position. For example, passive investors may have seen the frightening stock plunge in October 1987 as an opportunity to invest more in a proven manager such as Lynch. In any case, passive investors would have kept adding to their position when it was down, helping to boost their long-term returns.

Hitched to a star like Lynch, passive investors did phenomenally with an active manager. But that’s not always the case. Between 83% and 95% of active professional managers fail to beat their benchmark’s returns in any given year, so merely buying and holding an active manager is not the solution, unless you’ve found the next Lynch. Of course, some money managers are the next Lynch, but it can be difficult or impossible to find them before they’ve gone on their run.

Likely winner

Let’s break it all down in a chart comparing the two approaches for an investor looking to buy a stock mutual fund that’s either active or passive.

 Active fundPassive fund
* Over a 30-year period, per Dalbar’s 22nd Annual Quantitative Analysis of Investor Behavior, 2016
**ICI Research Perspective, May 2017
Returns3.7%*About 10% over time, the market average
ExpensesHigh, at 0.82%**Low, at 0.09%**
ObjectiveBeat the market’s returnsBe the market’s returns

In the end, passively investing in passive funds looks like the winner for most investors.

Perhaps the easiest way to start investing passively is through a robo-advisor, which automates the process based on your investing goals, time horizon and other personal factors. The robo-advisor selects the funds to invest in. Many advisors keep your investments balanced and minimize taxable gains in various ways.

Almost all you have to do is open an account and seed it with money. And then back away.

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