Passive vs active investing: why passive wins

We might as well be upfront: the passive vs active investing debate isn’t much of an argument. On one side is a mountain of evidence in favour of passive investing. While on the active investing side is a mountain of marketing money attempting to keep a very profitable show on the road. 

It’s a story not unlike that of the tobacco or oil industries facing down their own inconvenient truths. Where the corporate incumbents deploy cash like nails under the wheels of progress. Slowing down change for as long as possible by befuddling consumers in a fog of doubt and alternative facts. 

That said, what is the case for passive investing?

In a nutshell:

Active investing returns aren’t consistently good enough to overcome their higher costs. Over a lifetime, this means that passive investors will earn higher investing returns than active investors, on average. 

Below we’ll walk through the key passive vs active investing evidence that justifies this conclusion.

What is passive vs active investing?

Passive investors hold entire markets, such as global equities or UK government bonds. The evidence suggests this low-cost, low-turnover diversification across key asset classes is a winning investment strategy for most people. 

Each such market is defined by a benchmark index such as the MSCI World, S&P 500, or FTSE All-Share.

Passive investments such as ETFs or index funds replicate those indexes very efficiently. In doing so they enable investors to hold a whole market like UK equities in a single vehicle.

This makes index trackers the ideal way to implement a passive investing strategy. 

Active investors, by contrast, hold a particular subset of each market they care about. They (or their fund managers) pick the mix of funds, individual shares, or other securities that they believe will do better than the rest. (“Outperform,” or “beat the market,” in the jargon.)

Active investors may also time their trades – trying to stay ahead of current events like surfers riding a powerful wave. 

But active investors can be dragged down by their efforts to beat the market. They may misread events, choose the wrong securities, or incur such high costs that they earn worse returns than if they’d just taken the market average.

Passive investors, meanwhile, accept they do not have the skill to beat the market. They therefore choose low cost index trackers that reliably deliver the average market return, minus the wafer-thin fees necessary to run these funds.  

By investing enough money, into the right combination of assets, for enough time, passive investors aim to achieve their financial objectives by earning the market return. 

Thus active vs passive investing is the financial version of the tortoise vs the hare. Slow and steady wins the race. 

Passive vs active investing evidence

The reason why passive investing is better than active investing largely boils down to costs. 

Nobel Prize winner William Sharpe laid out the mathematical reasons why passive funds prevail.

When you look at the total population of investors:

Passive investing delivers average returns minus low costs

Active investing delivers average returns minus higher costs

The lower your costs, the more of your money you keep. The higher your costs, the more your money is diverted to some Ferrari-driving fund manager.

Passive investors beat active investors as a group because both earn the same returns on average – but passive investing costs are lower. (See the Financial Conduct Authority evidence on the damage wrought by fees below.)

Sharpe showed that the total market return is the sum of all investors’ returns. By definition, the market must encompass all investors who outperform and those who underperform:

That sum of outperforming and underperforming active investors is the reason why active investing is a zero-sum game

The winning investors earn their gains at the expense of the losers. 

But passive funds stand aside from this ferocious competition. Index funds and ETFs are designed to capture the return of their market. They do this reliably because they own that entire market. They don’t seek to profit from owning a particular slice in the hope of outperforming. 

As a passive fund investor this means you can count on achieving the average market return – less the slim costs needed to run the fund. 

Active investors as a group are similarly left with the same average market return. But crucially they must then deduct higher costs. 

Hence the passive v active investing debate ends in a win – on average – for passive investors. 

Passive vs active investing as explained by Warren Buffett

Investing legend Warren Buffett explains the logic of passive v active investing similarly:

A lot of very smart people set out to do better than average in securities markets. Call them active investors.

Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund.

Therefore, the balance of the universe – the active investors – must do about average as well.

However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors. 

Active investors are betting that they can find a combination of securities that enable them to consistently beat the market. 

They believe they will rank in the set of winners who achieve higher than average returns. 

They do not believe they will fall into the set of losers who inevitably weigh down the results of active investors overall. 

If they thought they were doomed to underperform then they’d buy passive funds and accept average returns. 

Some people are fooling themselves. All active investors must believe they’re above average. But we know it’s impossible for everyone to be above average. 

In fact the evidence shows the majority of active investors overestimate their chances of beating the market. 

Active vs passive investing: why amateurs get fleeced

The competition between professional active investors is fierce. The stakes are sky-high: if you can consistently beat the market then you’ll rake in fabulous wealth. 

Ordinary investors try their luck, too. Picking stocks on trading apps. Perhaps investing in an industry of the future like AI, robotics, or healthcare. 

But remember active investing is a zero-sum game. Winners pick the pockets of losers.

And ordinary investors don’t realise that most of the time they’re competing against huge financial players. They’re kitted out like Mr Blobby on a battlefield stalked by giant terminator droids who use amateurs for target practice. 

Civvie active investors pit their stock tips and hunches against smart-money war machines deploying ranks of quantum physics PhD.s, advanced AI, data connections powered by lasers, terabytes of industry intelligence, and a relentless 24/7 work ethic. 

Some active firms have literally dug through mountains for an extra millisecond trading advantage.

David Swensen, the famed manager of Yale University’s endowment fund, candidly assessed the chances of ordinary investors in his book Unconventional Success:

Individuals who attempt to compete with resource-rich money management organizations simply provide fodder for large institutional cannon.

There’s a reason the finance industry calls regular folk ‘dumb money’.

Learn what to do if you’re an ordinary investor with no reason to believe you can beat the smart money.

Active vs passive funds: why picking a professional is a losing game

An alternative active approach is to outsource your strategy to someone who promises to smash the market for you. 

Intuitively it seems obvious. Find someone with a good track record, and let them spin your mini-bucks into megabucks. 

Sadly, this doesn’t work either. The long-running SPIVA study shows even most investment industry professionals can’t outperform for long. 

A whopping 62% of active fund managers investing in UK equities failed to beat the market over the ten years prior to the end of 2021.

It gets worse.

90% actively investing in global equities failed to beat the market across the same decade.

95% of actively managed equities funds investing in the US failed too.  

Some managers do buck the trend for a while. And a few maintain their winning streak for years. They’re hyped like the Second Coming by a finance industry eager for miracle workers. 

But like aging prize fighters, most are brought down eventually. Neil Woodford being the most spectacular crash and burn in recent UK investing history. 

The evidence against persistent active manager outperformance led the FCA to conclude:

It is widely accepted that past performance is not a good guide to future performance. We find that it is difficult for investors to identify outperforming funds. This is in part because it is often difficult for investors to interpret and compare past performance information.

Even if investors are able to identify funds that have performed well in the past, this past performance is not likely to be a good indicator of future performance.

Picking an active fund on the basis of dazzling recent results is like handing your money to someone who just hit the jackpot on a fruit machine. There’s no guarantee they can repeat the performance. There’s many reasons to think they won’t.

They don’t make their money by beating the market

Failure isn’t worth the risk when your financial future is on the line and that’s why we recommend using a passive investing strategy.

This is difficult to credit in the face of active investing propaganda – and even common sense.

So let’s turn again to Warren Buffett, the Sage of Omaha, for a dose of his condensed wisdom:

Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades.

A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.

There are a few investment managers, of course, who are very good – though in the short-run, it’s difficult to determine whether a great record is due to luck or talent. 

Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship.

The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well.

Remember we’re not saying that active investors can’t beat the market full-stop. Some do.

But active investing is like a sea seething with mosasaurs and megalodons. People get eaten for lunch all the time. And it’s rare for even the biggest of beasts to stay on top for long because this is an ultra-Darwinian competition, red in tooth and claw. 

Knowing this, the finance industry long ago realised it’s easier to profit from high fees and the human desire to believe we deserve better than average. 

A UK academic study by Blake et al points to the true beneficiaries of active management:

Although a small group of ‘star’ fund managers appear to have sufficient skills to generate superior gross performance (in excess of operating and trading costs), they extract the whole of this superior performance for themselves via their fees, leaving nothing for investors. 

Passive vs active investments: the importance of costs

An FCA report on the UK asset management industry confirmed the passive vs active fund findings of academics like Sharpe and investing insiders like Buffett:

Active funds for sale in the UK, on average, outperformed benchmarks before charges were deducted, but underperformed benchmarks after charges on an annualised basis by around 60 basis points.

Now, that cost gap doesn’t sound so bad. Which helps explain why many people risk taking the active side of the passive vs active investment bet.   

But the FCA produced this chart to show how much wealth active management can leech during quite a short investing lifetime: 

The graphic compares the ultimate returns (after costs) to an investor in typical UK funds:

Passive investing returns (red line)
Active investing returns (blue line)

The passive investor’s returns are 44% higher than the active investor’s.

It’s a tiny discrepancy at first. But the higher fees lever open that 44% gap that’s a trough of City riches.

For many people that could be the difference between enjoying a secure and comfortable retirement versus living in fear of running out of money.

The reality of being on the wrong side of the passive vs active investment cost gap is even worse than illustrated though. 

Your investing horizon could easily last over 60 years when your wealth-building phase is added to your retirement years. 

That’s a long time for high fees to negatively compound against you.

The upshot is that active vs passive fund costs make a critical difference over a lifetime. Do not underestimate them.

Don’t fall for it

If you still find it hard to believe that a multi-trillion dollar industry can largely be based on smoke and mirrors then let’s get a final sense check from Warren Buffett:

The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.

Both large and small investors should stick with low-cost index funds. 

Enough said. 

Take it steady,

The Accumulator

P.S. Many other investing luminaries have spoken in favour of passive investing vs active investing. The Investor has put together a small selection.

There is also much more research available from the academic community that finds overwhelmingly in favour of passive investing.

An interesting starting point is the literature reviewed by the FCA. You can find a list of sources on page 104 and 115 of the FCA’s Asset Management Market Study – Interim Report.

The post Passive vs active investing: why passive wins appeared first on Monevator.

Passive vs active investing? Passive wins by a landslide. Here’s why.
The post Passive vs active investing: why passive wins appeared first on Monevator.