“What could be more advantageous in an intellectual contest – whether it be bridge, chess, or stock selection – than to have opponents who have been taught that thinking is a waste of energy?”
~Warren Buffett
The debate between passive and actively managed money has been ongoing since the 1970’s when Jack Bogle started Vanguard. Over the last decade it would seem as though passive, low-cost index funds have declared victory as investors have been speaking their minds on the matter with their actual portfolios by shifting money in droves. But when it comes to Wall Street and investing, when something seems to be a heavy, one-way street, it usually pays to go the other way. I thought this post would be useful since it affects nearly everyone investing money, whether you’re investing money in a self-directed brokerage account or through a company retirement plan like a 401(k).
The truth of the matter is that there is a right place for each style of investing in a portfolio, and pros and cons to each. It’s more about understanding the differences and knowing when it might be best to use one approach over the other.
My personal opinion is that active management is typically smarter if the “activity” is focused on risk management. However, I’ve noted in the past how approximately 80% of actively managed mutual funds tend to underperform their benchmarks each year which is why I rarely invest client’s money in actively managed mutual funds. The difference between you being able to invest in some sort of “active” manner (tactical might be a better term) and a mutual fund manager, is that you don’t have to worry about short-term performance reporting and the risk of losing investors or your job. Active mutual fund managers do and because of this most of them end up being closet index funds with higher expenses – hence the annual underperformance.
As I mentioned above, I feel that active management is best when focused on risk management. Actively managed funds tend to outperform during bear markets but underperform during bull markets, so one application could be to switch money into actively managed funds that typically invest with a conservative tilt if you’re nervous about the markets. If things are going well economically and nearly all companies are enjoying the good times, maybe an index fund will work just fine.
I bring this up now because there has been a lot of attention in the media lately talking about the underperformance of so many active funds, especially hedge funds, and why everyone should just use low-cost index funds. Danielle DiMartino Booth, former advisor of the Federal Reserve Bank of Dallas, just wrote a great piece on the matter that I highly recommend reading. It details some of the potential pitfalls that index fund investors face moving forward. You can find it here.
Thanks for following!
-Nick