Does active beat passive investing?

You don’t meet too many people who will admit to taking a passive approach to life, especially in Boulder County with all of our business startups and uber athletes. The word “passive” implies languid days on the beach, disinterest, and an overall lack of vigor. Active, on the other hand, projects industriousness, insight, and dynamism. Not only can we use active and passive as words to describe human behavior, but we can also use them to categorize investment approaches. When applied to mutual funds or exchange traded funds (ETFS), active investors start with the mindset that they can beat the market. And active investors come in all shapes and sizes. For example, your neighbor who has a hunch about a stock can be an active investor, as can be a sophisticated investment firm that has a process to select stocks that they believe will perform better than their peers. An active manager seeks to outperform the market through fundamental analysis regarding the future profitability and growth of a particular company. On the other hand, a passive investment manager usually has a target index that it tries to mirror by purchasing the stocks in that index. Perhaps the oldest example of this is the Vanguard 500 Fund. Vanguard does not try to pick the best large company stocks in this fund. Instead, they do their best to have a large portion of their capital invested in those 500 stocks every trading day.

Every year S&P Dow Jones Indices generates the SPIVA scorecard that analyzes the performance of thousands of actively and passively managed investments in scores of different categories, including U.S. large company stocks. While the report for last year has not yet been released, if it’s like past years, the conclusions will be the same. In any given year, most active managers tend to underperform the index appropriate for their mutual fund or ETF. The record for active managers becomes more uniformly poor for longer periods.

The SPIVA mid-year report released June 20, 2023, showed that in a six-month period, 60 percent of active U.S. large company funds underperformed the S&P 500. Perhaps even more astonishing is that the report also looked at the historical performance in that category and found that in only three out of the last 23 years did most active managers outperform the S&P 500.

This record of remarkably consistent underperformance compounds over time. Over the last three years 80 percent of active funds in the category underperformed the benchmark. Looking 15 years back, 92 percent of active managers underperformed the index. This poor record is not just limited to the U.S. large company stocks. In fact, there is not a single U.S. investment category in which most active managers performed better than the index over a 10-year period.

How can active management perform so much worse than passive? Investment costs are perhaps the most significant factor. Passively managed funds are, by their very nature, low cost, with some funds having annual fees of 0.04 percent or less. Actively managed funds are more expensive to run. You need to hire managers with sterling qualifications who can build their brand as a superior stock picker. The manager will often hire a set of analysts to scour for companies that will outperform their peers. Fund companies will spend considerable amounts on marketing if their fund has a promising track record. There’s also the cost of buying and selling individual stocks with much greater frequency than a passively managed fund. It can also

be hard for active managers to have close to 100 percent of their fund invested in stocks as “good ideas” may not present themselves every quarter.

Active fund managers have a tough lot. It’s not enough for their stock picks to perform as well as the index. They must consistently beat the index to overcome their inherently higher cost structure. While it’s true there are a few managers who have performed above average over time, that outperformance can be fickle. Many a star manager has descended into sub-mediocrity after a promising start. Overall, the odds are stacked in favor of passively managed funds.

David Gardner is a Certified Financial Planner™ professional at Mercer Advisors practicing in Boulder County. Opinions expressed by the author

are his own and are not intended to serve as specific financial, accounting, or tax advice. They reflect the judgment of the author as of the date of publication and are subject to change. The information is believed to be accurate but is not guaranteed or warranted by Mercer Advisors. The hypothetical examples above are for illustration purposes only. Actual investor results will vary. Every individual’s situation is unique, and you should consider your investment goals, risk tolerance, and time horizon before making any investment decisions. For financial planning advice specific to your circumstances, talk to a qualified professional. Mercer Global Advisors Inc. is registered with the Securities and Exchange Commission and delivers all investment-related services. Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services.