The Case for Passive Investing

There are two basic approaches to investing in stocks: active investing and passive investing. Active investing is an attempt to beat the overall returns of the stock market by buying undervalued shares. This can be pursued through the purchase of individual stocks or actively-managed mutual funds. The active investing approach assumes that there are inefficiencies in the market pricing of securities that can be exploited by savvy investors. However, there is no evidence that this is possible on a consistent basis.

Passive investing is based on the idea of market efficiency. A passive investor captures the market rate of return by investing in a group of stocks selected to match the performance of a standard stock market index. A variety of such indexes have been created to serve as benchmarks for the various segments of the market. For example, the S&P 500 index tracks the performance of large capitalization U.S. companies, while the Wilshire 5000 tracks the overall market. There are additional indexes for small-cap stocks, mid-cap stocks, value-oriented stocks, growth stocks, foreign stocks, and other categories.

The most common approach to passive investment is to buy shares of an index mutual fund. When an index fund portfolio manager buys a stock for his or her fund, it is typically held indefinitely, unless the company is deleted from the index. The simplicity of this approach helps keep index fund expense ratios well below the expense ratios of actively-managed funds.

The most compelling argument in favor of index funds is that they provide greater returns than actively-managed funds over time. The Wall Street Journal recently reported that the average mutual fund underperforms its risk-adjusted benchmark by 1.4% per year. Of course, there will be some actively-managed funds that outperform their relevant market indexes in any given year. However, only a tiny fraction of funds outperform the market over periods of five or ten years and it is impossible to identify them prospectively.

Most people select actively-managed mutual funds based on past performance. Morningstar ratings and the many lists of "all-star" funds published in newspapers and magazines each year are primarily derived from historical performance. The problem with this approach is that past performance has almost no predictive value for future performance. Academic research has shown that mutual fund managers with great track records are no more likely to have good records in the future than are managers with poor returns.

The findings of academic research are clear. Over time, index funds have consistently outperformed actively management funds. Index funds also charge lower fees and are more tax-efficient than actively managed funds. The facts overwhelmingly favor a passive investment approach.

Table 1. The Case for Passive Investing

• Ensures that you capture market rates of return
• Lower cost than active management
• More tax-efficient than active management
• Supported by empirical evidence
• Supported by Modern Portfolio Theory

Back to learning Center

Recommended Reading for Investors