Back to Basics – Active Versus Passive Investing

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What investing philosophy do you have?

If you’re looking to hire a financial planner, one of the first topics that will come up is the adviser’s investing philosophy.  However, before you talk about the adviser’s philosophy, you should think about your own investing approach.  Some planners will say that they believe in ‘actively managed investments,’ while others will state their preference for ‘passive investments.’  This article attempts to explain the difference in those investing philosophies so that you can better understand what you might be looking for in your financial planner.

Introduction

Before we go into depth on this, let’s take a look at the role of a financial planner.  The overall role should be to help you, as the client, become more comfortable with the way money impacts your life and to help you make decisions with your money to allow you to do what you want in life (that’s my goal, anyway).  However, based upon their education, experience, and employment history, a financial planner may have varying opinions regarding the role of investments.  Some advisers who may have investing experience, either picking their own stocks or having previously worked for a broker-dealer, might tend to heavily stress the role of investments in your financial life.  Other advisers may stress other items as more important, such as insurance (insurance representatives), estate planning, financial management, or any number of other aspects that comprise the complex relationship between you and your money.  This distinction will lead us to the relationship between active and passive investing, and the ways in which they are different.

Investing Philosophy 

The philosophical difference between active and passive investing simply reflects the difference in the investing approaches mentioned above.  Someone who believes in an active approach will believe that a technically sound investor or investment manager can select individual securities (stocks, bonds, commodities, or other investments) that will outperform the market as a whole.  Someone who believes in a passive investment philosophy believes that it is better to use index-based securities (such as an S&P 500 index mutual fund or ETF.  An ETF, or exchange traded fund, is similar to a mutual fund, except that it trades like a stock).  The thinking here is threefold:

  1. Investing Performance. Most active investors underperform against the index they’re competing against.  For example, the 2014 SPIVA (which is basically the Standard & Poor’s scorecard that shows how well actively managed funds perform against various indices) showed that 86.44% of active large-cap mutual fund managers failed to match the S&P 500’s performance over a 1 year period.  This trend holds true for mid-cap funds (66.23% of managers underperformed the S&P Mid-Cap 400), & small-cap (72.92% underperforming the S&P Small-Cap 600).  In fact, in the 2014 SPIVA, there was not a single asset class in which active managers outperformed the index they were tracking.  However, to look at any of the advertising material, it seems that all the actively managed funds beat their index, or the average return.  It’s like we’re living in Lake Wobegon, and all the children are above average.  You have to take a step back to realize there’s something wrong with that picture.
  2. Time. Many financial planners feel that the time and effort that go into researching stocks could be better spent finding other ways to deliver value to their clients.  For example, instead of 4 quarterly investment reviews per year, a tax-focused adviser might substitute one of those meetings for a tax planning meeting.  If, during that meeting, the adviser and her clients might find a tax planning opportunity that saves $1,000 in annual taxes.  Over the course of a year, it would take a 1% outperformance on a $100,000 portfolio (which most managers seem to have difficulty in achieving) to accomplish something that many people discover over the course of a two-hour tax planning session.  You could uncover similar opportunities in cash flow management, an insurance review, estate planning, or just identifying ways to move into less expensive investments.
  3. Value proposition. Many passive-approach believers insist that advising on low-cost, index-based investments allow them to keep client costs down, and deliver more value.  We’ll get into cost in the next section, but it’s true.  An adviser who can save their client 1% in fees and demonstrate that value to their client is one who will probably keep that client for a long time.

Cost

Cost is directly tied into an adviser’s value proposition.  While it’s not sensible to go with the lowest cost investment adviser (any more than you’d buy the lowest cost bicycle helmet for your children), there is not a very clear correlation between price and value when it comes to financial advice.  You can find very competent, capable, and personable financial planners who charge reasonable rates (or can demonstrate their value proposition is much more than the cost of their services), and you can find complete jerks who do nothing for you and charge exorbitant fees.  However, when it comes to mutual funds, with a little research, you find that the average active fund is significantly more expensive than its passively managed counterpart.

According to a 2015 Morningstar study, the asset-based average expense ratio for a passive fund is .20%, versus the average active ratio of just under .80%.  The great news is that over the past 20 years, financial education has led to consumers moving more and more out of active funds and into passive investments.  This outflow of money from the active funds has driven down their cost, but they’re still much more expensive than a passive portfolio.  To put it into perspective, this .60% difference on a $500,000 portfolio represents $3,000 per year.  A good financial adviser who is able to demonstrate this kind of savings (and make sure your money is still wisely invested), will probably be able to uncover a lot of other financial planning opportunities and demonstrate their value.

Summary

Hopefully, this article helps to shed some light on the differences between active and passive investments.  While I tried to keep this unbiased (you might have figured out that I’m a fan of the passive investing approach), it became more and more difficult as I started putting together the information.  I’m sure there are some mutual fund managers and advisers out there who can justify their extra costs.

However, when you look at the facts, it’s pretty clear that there’s a better place for you to put your time and money than in trying to outperform the stock market.  And quite frankly, you should have that same expectation of your financial adviser—spending their time in the areas that make the most sense for their clients.

About Forrest Baumhover

I'm a career naval officer, and a fee-only financial planner. Half-way through my career, I discovered that I had a passion for financial planning, and have pursued this as my second career. My specialty is working with military professionals who are looking to separate or retire from the service, and who feel they need some professional guidance to make sure they're on track.
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