If you ever want to start an argument amongst wealth managers, just ask which they think is better: active investing or passive investing.
While many investing arguments can be settled rather amicably, this debate has led to several publicized disagreements or wagers, including Warren Buffett vs Ted Seides.
Back in 2008, The Oracle of Omaha, Mr Warren Buffett, bet that no set of five actively managed funds could outperform the S&P 500 Index (a passive investment strategy) over ten years.
A hedge fund manager named Ted Seides took him up on it, and picked 5 hedge funds that he thought would outperform the S&P 500.
And to make it a little more excited for them, they decided to each throw in a half a million dollars and have the winner donate the sum to the charity of their choice.
The outcome? Well, not so fast. First, let us understand why this is a major topic and let you decide whose side of the wager you’re on.
What is active investing?
Active investing is when funds or investments are actively managed by a financial expert, or more likely, a team of experts. The aim is to develop a set of stock picks that will beat an index, which is their benchmark. The most common index they try to beat is the aforementioned S&P 500, which makes up the largest 500 companies in the US stock market.
Despite what some online influencers say on TikTok and Reddit, this is a lot harder than it sounds. This is a complicated process that involves qualitative and quantitative analyses to determine stock valuation, market swings and economic forces.
The success of active investing depends on the manager’s ability to accurately determine when stocks should be bought and sold, consistently. And consistently is the key word. Sure, you can get one pick right one time, but if you can’t do it consistently, there’s no way you’ll outperform over time.
From my own experience, there are a lot of people who have stories of picking a single stock or two that has gone up in the last few years. But here’s the thing: the entire US market has done extremely well the last decade, and especially the last three years. As of me recording this episode, the last three years the S&P 500 has an average annual return of 24.88%! That’s incredible, and no, it won’t last. So anyone who has picked single stocks in that timeframe has benefited from everything in the market being up.
What is passive investing?
Passive funds simply track an index and match it as closely as possible. However, this is not to say that there is no human involvement at all. In most cases, fund managers may be required to make minor alterations to the fund to better track the index.
Passive investing is a long-term approach, which follows the buy and hold strategy. This means that you are not buying and selling based on the ups and downs of the market, and it also means that they are not ananlyzing single stocks to find out which ones will do better than the rest in the future. Instead of picking a few stocks that they think will be winner, passive investors buy very small pieces of thousands of different companies, and enjoy their increase in value over time.
People who buy into passive investing acknowledge that they won’t “beat the market”, since that isn’t possible, because the whole purpose of passive investing is to track indexes, not to beat it. And they are perfectly okay with that. Their goal isn’t to get the highest return possible out of all the investments available in the world. Their goal is to get solid investment returns, typically by owning a few different passive investments that track different things, which helps increase their diversification and increase their return.
Active Investing vs. Passive Investing: Pros and Cons
Given their respective ideologies, it is pretty clear which investing type should perform better. But before we give that away, we need to look at the pros and cons of each investing type and see how that impacts investors.
- Fees
Both investing types require at least some level of management, and so both charge what is called an expense ratio or management expense ratio. An expense ratio is simply how much a fund charges for its services.
Understandably, actively managed funds charge more.
According to Vanguard, the average passive, index fund fee is 0.24%. And according to Morningstar, the average actively traded mutual funds averaged 1.45%.
Given the high costs charged by active funds, they need to deliver much higher returns in order to outperform an index, which doesn’t always happen. Even if there’s “only” a 0.5% difference between active and passive investments,w while that might seem small, but it really adds up over decades.
- Flexibility
One major drawback in passive investing is that the fund is unable to react when there is a problem in the market. Let’s take 2020 for example and the decline in value of cruise liners and the tourism industry.
While these companies were going down in value, like everything else, there is nothing an index fund would have been able to do about it in the short-term.
An actively managed fund on the other hand, could have withdrawn all of its shares in Royal Caribbean, for example, and put them into Tesla or Netflix.
Admittedly, this isn’t something that happens all the time. And even when it does, you have to have the foresight to know what to sell, and then to know what to buy. But if you can pull all of that off, which most people can’t, then those kinds of moves can boost your returns.
- Transparency
If you always want to know which stocks are in your fund, then your only option is with passive investing. Actively managed funds may fluctuate on a daily basis, and they will only report on what companies they hold at the end of each quarter. But that doesn’t mean that they held all those companies the whole quarter. So it’s harder to track.
So, if you want certainty about what you own, passive investing is the only way to assure transparency.
- Active risk
The major indices have performed solidly over several decades. While we know we cannot predict future market performance, and we also know historical returns do not guarantee future performance, we can see that if the past holds true then you can expect a pretty decent return from owning diversified index funds over a long period of time.
However, given the constant changes with active investing, there is a lot more risk involved. You could potentially outperform the passive index funds, but that is not a guarantee. And there’s more than a decent chance that you won’t do as well as index funds.
- Tax efficiency
A passive index strategy, where you buy and hold and monitor, is very tax efficient as you will only pay capital gains tax when you’re ready to sell. There may be some small distributions if a company was replaced, but those distributions are usually quite small.
On the other hand, if you are actively investing on your own, or you own funds that are actively trading, you may pay short-term capital gains tax every year, which is taxed as ordinary income (and not the lower long term capital gains rate). If that happens to you consistently over time, that will eat into your returns.
Which Investing Strategy Has Better Returns?
For many years, active investing has been a very popular option for investors because they want to beat the market, even though the S&P 500, and other indices, perform quite well. In the past decade, the S&P 500 has yielded 13.6% annually, yet for some investors that isn’t enough, especially as it is not uncommon to hear of active funds that have yielded more than 100% in a given year.
However, the question isn’t whether an active fund will perform better in one year, but over a long period of time. The simple answer is “No!”
The reality is consistently outperforming good, low cost index funds is extremely difficult. Mid 2020 to Mid 2021 was deemed one of the best years for actively managed funds, yet only 47% outperformed passive index funds, according to the Morningstar Active/Passive Barometer. And that’s the best they done in awhile!
In the past decade, only 25% of active funds did better than their passive competitors. And when comparing large-cap equity funds, which are compared to the S and P 500, that number drops down to 11%. While the high fees are part of the problem, the reality is most stock pickers aren’t great, which is why 40% of active funds go out of business within ten years.
So, what does this mean for the investor?
While it is possible for active funds to outperform passive funds, there is no guarantee, and in fact the odds are stacked again you, and against the active fund manager. To me, that makes index funds your best bet.
Final Verdict
Back to where we started; who do you think won between Buffett and Seides?
Well, as you may have guessed, Buffett did. And it wasn’t even close!
At the end of the 10 year period, Buffett’s pick of the S and P 500 got a 99% total return, which on a yearly basis is around 7.1% annualized. Mr Steides’ 5 actively managed funds got a total return of 24%, or 2.2% annualized per year. So like I said, this wasn’t particularly close.
To put this in perspective with actual dollars and cents, let’s compare how much you would have after 10 years if you started with $100,000 and didn’t contribute anything after that.
Under the S and P 500 strategy favored by Warren, at the end of 10 years you would have $198,561.35.
Under the five active fund strategy favored by Mr. Seides, at the end of 10 years you would have $124,310.83.
So that’s a $74K difference just by picking a low cost, well diversified portfolio where you are not trying to time the market, not trying to beat the market, and just trying to get solid returns. Sounds like a winning strategy to me!
And I hope you’ll agree with me that the best strategy as you plan and enter retirement is to have a low cost, well diversified portfolio to help you create that retirement income you want.
As always, if you’d like help making sure your investments are sound, I’d be happy to help. You can schedule a call with me at statmyretirement.us and we will create a one-page retirement plan for you.