The last few years has brought a dramatic change in the attitude to the investment process. Classic actively managed investment funds have slowly been replaced by passively managed funds (ETFs), which in their investment strategy, simply follow the structure of the main indexes, for example US index S&P 500.
Passive investment is becoming main stream, as the flows to Exchange Traded Funds (ETFs) are rapidly increasing.
So Passive or Active – which one is the better investment strategy and why? This long-running debate has been partially resolved by the legendary investor Warren Buffet. In 2007, Mr. Buffett made a $1 million bet against Protégé Partners that hedge funds wouldn't outperform an S&P index fund over the next 10 years.
Buffett's choice fund, the Vanguard 500 Index Fund Admiral Shares, which tracks US index S&P 500, returned 7.1 % compounded annually, while the basket of the hedge funds his competitor chose returned an average of only 2.2% annually. So, in 2018 Mr. Buffet won his bet and gave an additional argument for those who claim that passive investment is more effective way of investing money over active investing.
Passive investing is usually the most efficient way of investing money, primarily because of the much lower costs. To understand the difference, we need to investigate the investment process.First of all, active investing is where a fund manager picks the stocks which he thinks will do the best. This traditional approach is based on the accumulated knowledge and experience (and often a little bit of guesswork, too) of active fund managers, who try to 'beat the benchmark' by picking inpidual company stocks that they think will do the best for their investors. The term 'Beat the benchmark’ simply means they need to get a better return than the market does overall – represented by the S&P 500, Dow Jones or another market index. Otherwise, investors may choose to invest in a market tracker and save significantly on their fees and be on par with the market.
Unfortunately, picking the winners in actively managed funds sounds a lot easier than it actually is.
Research shows that, for example, in 2010-2015, a staggering 89% of fund managers failed to beat the market each year – getting less return for their clients than if they’d just bought a simple market tracker. But that's not all.
Beating the market in two subsequent years is even less likely. Even if you do manage to beat the odds and choose one of those 11% of fund managers who do outperform the market, research shows that they're no more likely to do so next year or any subsequent years. In other words, picking the best fund manager is just as difficult as picking the best stocks. So, the only thing you can really be sure of with active investing is the managers' high fees. Also remembering that while investing your capital is at risk.
Passive investing is the more modern approach, emerging in the 1970s as a remedy to investors’ frustrations with actively managed fund performances. Originally known as index funds, they’re now more commonly called tracker funds or Exchange-Traded Funds (ETFs). They work by tracking a market index, like the S&P 500, thereby linking investors' performances directly to that of all the companies in that market, rather than just one or two. In the case of the S&P 500, it’s the 500 biggest publicly-traded companies in the US, names such as Apple, IBM General Motors etc.
In practice, passive investing means instead of putting your hopes (and money) on two or three companies, you back them all on the basis that some will have a bad year, while others will have a good or very good year. The theory is, that the positive returns will cancel out the negative returns and the market ends the year with positive growth for investors, which historical figures show, more often than not, it does.
Passive investing is the equivalent of backing every horse in the race and that’s why passive investing is generally seen as a steadier and less risky approach.
But buying the whole market should be more expensive, right? Not necessarily and given the economy of the scale, it's actually cheaper than buying typical actively managed mutual funds. The service fees and other charges paid for passive investing are actually much lower, as a result of the fewer fund managers and overheads required to operate. As if that wasn't enough, research prepared by Morningstar shows that the cheaper the passive fund is, the more likely it is to give you a better return on your money - so in the investing world, cheaper really is better.
Well, Active investing may have a place for certain investment goals, but if you want a low-cost, lower-risk, steady long-term investment strategy that will give you good overall returns, then passive investing seems to be a right way to go.