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Passive vs. Active Investing: Which team are you on?

Passive vs. Active Investing: Which team are you on?

Andrew Crowell, Vice Chairman, Individual Investor Group

The popularity of low-cost passive investment strategies has garnered significant press recently, leading many to question if active management is dead or simply doesn’t work. Underperformance of the average active investment manager has certainly added fuel to the fire, as investors search for cheaper index alternatives.

Typically marketed as low-cost and diversified approaches, passive index strategies provide financial market or sector exposure and approximate benchmark performance. According to Morningstar, assets under management in passive mutual funds have exploded 230 percent globally to $6 trillion since 2007, whereas actively managed funds have grown only 54 percent over the same time.1 Yet, the fact that numerous investment fads have come and gone begs the question of whether the current herd mentality of passive-only won’t potentially suffer a similar fate. If everyone is doing it, is it really the best strategy or is it simply a crowded trade that ensures long-term average outcomes, irrespective of the low-cost fees? Time will tell, but typically the best portfolios are built to meet each client’s individual needs and include a mix of both active and passive investments.

Passive vs. Active

There are many studies that look at the performance of active and passive strategies, but the important step of asking investors if “beating the index” is actually their goal is often overlooked. Advisors know that their clients should be focused on defining goals unique to their own situations, as most investors do not fit comfortably in an index “box.” They have individual preferences, goals, worries and dreams. The translation of these objectives into a cohesive plan results in a “Personal Index,” which may or may not have any relation to benchmark performance. Will I have sufficient health insurance coverage during retirement? Can we travel the way we planned? Can we afford to help our grandchildren with college? Objectives like these are the most important targets for most investors, not a benchmark. While one goal might best be served by a passive-heavy strategy, another might benefit from a more active approach. Beating a benchmark is an empty victory if it means an investor is not meeting their financial priorities.

Another element misinterpreted in most studies is the actual time horizon of typical investors. Studies typically examine relatively short intervals (i.e., 1, 3 and 5-years) for comparisons of active and passive strategies rather than the 20 and 30 plus-year horizons of most investors. Looking at longer time spans can reveal sharply different conclusions. A study from The Capital Group looked at total investment results from 1934 through 2015 and revealed that their actively managed funds outperformed their respective indexes 85 percent on a 20-year basis and 96 percent on a 30-year basis.2 Since retirees are living longer and need their retirement nest eggs to last longer than ever previously believed, it’s imperative that investors and their advisors keep this long-term approach in mind.

So What’s the Answer?

Some might argue that passive indexing is yet another example of a disruptive technology that is changing the business of investing. While these passive strategies certainly may have their place in some investors’ plans, the most strategic portfolios include whatever solutions best serve an investor’s goals — typically a combination of active and passive investments. Investors are not “average” but rather individuals with unique preferences, worries and dreams. Expert counsel that translates these attributes into a well-crafted plan, tracked over time, is a better approach to ensure positive investor outcomes.

Information contained herein has been obtained by sources we consider reliable, but is not guaranteed, and we are not soliciting any action based upon it. Any opinions expressed are those of the author and based on interpretation of data available at the time of original publication of this article. These opinions are subject to change at any time without notice. Investors should consult their financial and/or tax advisor before implementing any investment plan.