Active vs. Passive Investing

By | Updated July 6, 2017 8:32 AM UTC

Are you good enough at picking stocks to beat the market? Not too many people would claim that. Is your asset manager good enough? The $10 trillion invested in active-management funds is a bet that the answer is yes. But more and more people are saying no. So is the world’s largest asset manager, BlackRock Inc., which is paring back its active-equities group. BlackRock is responding to a surge of money into what’s known as passive investing. It’s an approach endorsed by legendary investor Warren Buffett, who thinks the smartest thing your money can do is climb into a hammock and take the rest of the day off. The active vs. passive debate is upending the investment industry.

The Situation

A little more than a third of all assets in the U.S. are in passive funds, up from about a fifth a decade ago. In the first half of 2017, flows out of active and into passive funds reached nearly $500 billion. Vanguard Group, whose founder, John C. Bogle, created the first index fund for retail investors, has been a big winner from the shift, as has BlackRock. Some companies that specialize in active management, like Fidelity Investments and Franklin Resources Inc., both of which have seen investors leave, are slimming down. Others are merging or even closing. The trend toward passive has drawn in not only individual investors but institutions and even a lot of financial advisers. At Vanguard, more new cash now comes in via advisers than directly from individuals or retirement plans. Passive investments are also threatening hedge funds, which have drawn fire for poor performance and high fees. Buffett has estimated that investors wasted more than $100 billion on high-fee Wall Street money managers over the past 10 years. Not all active managers are pulling back, however: T. Rowe Price Group Inc. plans to expand the Baltimore-based firm’s distribution outside the U.S., create funds that invest in multiple asset classes and add data scientists to supplement the fundamental research it has relied on for 80 years.

The Background

Active investing is what used to just be called investing — buying or selling individual stocks or bonds. More commonly these days, it means putting money into mutual funds whose managers make those case-by-case decisions for you. Passive investments track indexes, which are groups of securities that are alike in some way. Buying an index fund or an exchange-traded fund that owns every stock in the S&P 500, for instance, is a passive investment. As an investor you will do as well as that overall market, no better or worse. In a 1973 book, economist Burton Malkiel, a Princeton University professor, claimed that “a blindfolded monkey throwing darts at the stock listings” could do as well as a professional money manager. Malkiel didn’t dispute the idea that some managers could outperform. But as a group, he argued, they would produce the same results as the market, minus the higher fees they charge. Bogle created Vanguard’s first index fund after concluding that because active mutual funds charge higher fees, their actual performance would generally be worse than their index counterparts. A typical active stock fund at Fidelity Investments might charge 70 cents for every $100 invested. Fidelity’s 500 Index Fund charges 5 cents. Even if an active fund produced somewhat better returns, over time the cost savings of the passive approach would outweigh that difference in performance.

The Argument

A 2016 study by S&P Dow Jones Indices showed that about 90 percent of active stock managers failed to beat their index targets over the previous one-year, five-year and 10-year periods; fees explain a significant part of that underperformance. In their defense, active managers say that the period since the financial crisis of 2008 has been an abnormal one, with many stocks moving in lockstep, rather than trading on their individual earning prospects. They say the phenomenon is likely to diminish as interest rates climb and the market moves into an environment that will play to the strengths of managers who pick stocks and bonds. Active managers also say that all the money pouring into indexes that treat good and bad companies alike will distort prices, creating more opportunities for those who can spot bargains and avoid overpriced securities, and pitfalls for those who rely on the wisdom of the crowd. Then there’s the question of whether active and passive investing are becoming more alike: As the number and complexity of exchange-traded funds and index funds grow, passive investors may end up with almost as many decisions to make as active investors used to face.

The Reference Shelf

First published July 6, 2017

To contact the writer of this QuickTake:
Charles Stein in Boston at cstein4@bloomberg.net

To contact the editor responsible for this QuickTake:
John O'Neil at joneil18@bloomberg.net