Active or Passive

Is it better to be active or passive? When it comes to investing, the answer might surprise you.

There are two basic approaches to investing referred to as active investment management and passive investment management. Active investing is an attempt to find "good deals" in the financial marketplace. An active investor looks for securities that will outperform their peers, and the market averages, going forward.

Passive investors aren't looking for good deals. Instead, they invest in broad sectors of the market, called asset classes. They also pay close attention to the relative allocation of their investment dollars among these asset classes. Examples of major asset classes include money market funds ("cash"), fixed income securities (bonds), and equity securities (stocks). Each major asset class can be subdivided into smaller asset classes. For example, equity securities can be split into small, medium, and large-cap stocks, as well as other categories such as growth and value stocks.

Asset classes are represented by various market indexes. Two of the most widely followed indexes include the Dow Jones Industrial Average and the S&P 500, which serve as proxies for large company stocks in the U.S. A plethora of additional indexes have been introduced representing different segments of the market.

The most common investment vehicle used by passive investors is the index mutual fund. An index fund matches the returns of a market index by holding all, or a statistically representative sample, of the securities that make up the index. A passive investor accepts the average returns within each asset class.

If you're like most people, you'll initially find the active approach to investing more attractive. After all, who wants to be average? Interestingly, this is one case where you can move to the top of the class simply by being average. Extensive research performed over the past 30 years has shown that most active investors underperform the market averages. In a typical year, about 75% of actively managed mutual funds lag behind their relevant benchmark indexes. Many investors are aware of this, but stick with active management in hopes of selecting funds in that elusive upper quartile. Unfortunately, this strategy fails because there is no way to predict which funds will beat the market averages in the future. Most people rely on past performance, which has almost no predictive value for future returns.

Nevertheless, it is difficult to avoid being seduced by a fund's brilliant track record. Take the Janus family of mutual funds, which have developed an almost cult-like following after several years of stellar performance. New investors piled into these funds during the latter half of 1999, only to experience mediocre market-lagging returns thus far in 2000.

In addition to outperforming actively managed funds, index funds also have lower fees and are more tax-efficient. Index funds are relatively easy to operate because they eliminate decision-making about which stocks to buy. Once a stock is purchased for an index fund, it is held indefinitely, unless the company is deleted from the index. The low portfolio turnover results in reduced expense ratios and significant tax advantages compared to actively managed funds.

You'll find that some people are quite vehement in defending active investment management. This is particularly true of active money managers who have a vested interest in continuing to collect their hefty fees. I'd like to emphasize that my belief in index funds is not based on dogma or ideology. Rather, it stems from a compelling body of evidence gathered by leading financial economists over the past three decades. I would switch to active investing in a heartbeat if someone could provide reasonable proof that it add value.

October 1, 2000

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