One of the most hotly contested debates in finance is the argument over which is better – active or passive investing. Moreover, this debate has spurred numerous academic studies that claim to identify whether passive outperforms active investing or vice versa. As a result, the current popular opinion suggests that passive outperforms active investing the majority of the time. However, the percentages can vary by a significant degree depending on who’s performing the study. Personally, I have seen numbers such as 85%, 91% and perhaps more commonly some will just say that the majority of actively managed funds fail to beat passively managed or index funds.
On the other hand, what I have yet to see is a clear definition of what an actively managed fund or portfolio really is. This has always been my biggest issue with these academic studies. The concept of passive is often more clearly defined as an index fund or portfolio. In other words, passive management is comprised of portfolios that mirror or match an index such as the S&P 500, etc. However, I have yet to see a clear definition of what constitutes or defines active management. Nevertheless, based on these criteria, I can only assume that any fund or portfolio that is not index based is included in the active management universe.
So my question is; how do you define active? Is it based on the amount of turnover in the portfolio, and if so, does every active manager in the studies have the same level of turnover? What strategies are being employed? Are all the active managers investing for growth, income or a combination of both? It seems to be clear what passive strategies are comprised of, but it is very unclear as to how the active category is defined.
But perhaps even more relevant to my skepticism is the implicit assumption that there are only 2 kinds of investing strategies-passive or active. Furthermore, these terms would also suggest that portfolio turnover or activity is the key differentiating factor. This really confuses me because even an index fund like the S&P 500 has turnover. In other words, stocks regularly come into and leave the index. Therefore, even an index fund has activity. So my question is; is there an activity or turnover standard or threshold that defines a portfolio as active? Furthermore, are these studies suggesting that any portfolio that is not an index has high turnover?
Therefore, one question I have, among many, would be; does a buy-and-hold long-term investing strategy fall into the active side or the passive side of the debate? For example, if an investor builds a portfolio of let’s say 30 stocks and never sells any of them, is that investor considered an active investor or a passive investor? Believe it or not, I have known investors that have done precisely that. They have bought and held stocks for decades.
And even more to the point is the undeniable reality that there are numerous investing strategies and many of them are not designed to beat the market. Instead, and for example, there are strategies designed to produce income, there are strategies designed to mitigate risk and there are strategies designed to meet specific investor objectives – and many more. Therefore, I consider the raging debate of active versus passive investing nonsensical. Attempting to define the broad universe of investing strategies as either active or passive is simply too restrictive and/or general to be of any real value.
How Do You Measure Performance and Should You Care Whether Active Beats Passive Investing?
Furthermore, where is it written that as an investor I should have the singular goal of beating the overall stock market on a total return basis? What if I need more income than the S&P 500 index is capable of generating for me? Therefore, if I build a stock portfolio that produces significantly more dividend income than the S&P 500, have I somehow failed as an investor because my capital appreciation component may be lower? Personally, I think not.
Moreover, if I am judging my success or failure based on outperforming a benchmark such as the S&P 500 on a total return basis, this could prove problematic to my goals and objectives. The problem with total return investing is that I become subject to the vagaries of short-term price action. As an income investor it is possible that I would be forced to harvest shares during a bad market in order to meet my income needs. Therefore, I would be invading my principal and doing it at a time when I might be better served to simply hold. But since I need current income, invading my principal is really not a viable option.
In contrast, if I have built a dividend growth portfolio that is producing an adequate amount of dividend income to meet my needs, short-term price volatility is of no consequence. For starters, short-term price volatility is very unpredictable and could work against me. However, since my dividend income stream is based on the number of shares I own, it is also more predictable and reliable regardless of what the market may be doing on a short-term price action basis. In other words, even when the market price of my stock is falling, my dividend income can actually be rising, assuming I picked the right dividend growth stocks.
Additionally, there is always the question of valuation, or perhaps more precisely – relative valuation. For example, if the overall market has produced strong results but is simultaneously significantly overvalued, should I really be happy about that? My current returns, if I was an index investor, might be quite good, but at the same time I could be facing significant future risk. Good returns in that scenario might lead me into a place of dangerous complacency. In other words, I could be feeling very happy even though I might be facing pending financial disaster when valuations correct.
Stated differently, what I’m referring to at this point is risk. Investing in the index at high valuation, which is where I believe we are today, would essentially be taking on more risk than I am comfortable with even though recent returns have been exceptional. Which leads me to my most favorite idiom that I personally coined: “measuring performance without simultaneously measuring valuation is a job half done.” Unlike a lot of investors, I get nervous when my performance is good primarily because valuations have become excessive. High valuations might have produced excellent short-term results, but they are also producing significantly higher risk at the same time.
Conflicting Studies on Passive Versus Active Investing
Although many people hold the view that the active versus passive investing records are conclusive, I have found that the records are anything but. Here is a link to an INVESTOPEDIA report that suggests that performance results can vary significantly depending on the timeframe and other factors. To me this simply further suggests that the results are anything but indisputably conclusive.
The Most Predictable Ways To Outperform The S&P 500
I believe that one of the more predictable ways to outperform the S&P 500, or any other index, is to behave as the S&P 500 behaves. However, I am not suggesting becoming what some refer to as a closet indexer.