Active vs Passive Investing Debate

Andrew Prentice |
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In my 13 year career as a financial planner I have not typically condemned certain products. All products have a purpose and if used in the correct situation for the correct person can add return or protection to a client’s plan. You may often hear people say you should never use annuities or you should never use a reverse mortgage. These two have been very divisive between the people who sell them and the people who don’t. I have recommended annuities (usually for income protection) but so far have never had to recommend a reverse mortgage. Hopefully this is due to planning for income ahead of time, but it could also be due to the types of clients I serve.

The most recent divide has been happening in the fund management industry between active and passive investing. For example, passive investing would be investing in the 500 largest US stocks, whereas active investing may try to pick 150 of those 500 stocks that they believe will outperform the 500 stocks. It usually boils down to if you think markets are efficient or not. If markets are efficient and all public information is priced into a stock, then no one could determine that a stock price is cheap and take advantage of the mispricing; therefore you would want to use passive funds. On the flip side, if you believe that markets are inefficient the manager of a fund may see something that others do not and take advantage of that misinformation to profit. In this case the use of active funds would pay off. My opinion is that most markets are fairly efficient, so using a majority of passive funds is the best way to go. I do use a couple of active funds, but you better fall in love with the managers you pick. These managers will have hard times where they won’t outperform the passive investments and when this happens you better be committed enough to stick with them in order to enjoy the good times that come in the future. I usually think of this relationship as a marriage - you know from the start it won’t always be sunshine and rainbows, but you did your upfront due diligence and have committed “till death do you part”.

The vast majority of the most recent research suggests that after fees and taxes active managers generally do not outperform their passive brethren. This is why you have seen a mass inflow into the passive fund space in the last few years. But continue to be careful, because just as the financial industry was great at selling these high priced active funds they are now coming out with more and more confusing passive funds modeled after esoteric benchmarks and indexes. This is why doing due diligence and consistently reviewing holdings should be done periodically by you or your financial advisor.