Active vs Passive Investing Understanding the Differences

Financial Advisor Tim Hayes

Warren Buffett once said of Jack Bogle, the founder of The Vanguard Group and inventor of index investing, ‘If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle.’ Sadly, Jack Bogle passed away in January of 2019.

With index investing, investors buy a basket of stocks or bonds. (Investors cannot directly invest in an index.) The most popular index is the Standard & Poor’s 500 (S&P 500), which tracks the 500 largest companies on the NYSE or NASDAQ.

Moreover, most stock market indexes, including the S&P 500, are market-cap weighted: the bigger the company, the more representation it gains on the index, and hence, in your investment option. Today, the largest holding represents approximately 3.7%, and the second-largest holding represents 2.6% of that index.

And, it is not just blue-chip stocks. Virtually any asset class can be invested in with an index that includes small-cap stocks, bonds, high-yield bonds, foreign stocks, commodities, and more.

Diversification and Investment Portfolio Design

However, Jack Bogle was not a fan of exchange-traded funds (ETFs), believing Wall Street would create an index for everything and that the trading aspect of ETFs ran counter to the long-term benefit of index investing.

During the coronavirus-induced selloff, many ETFs experienced large differences between their net asset values and their market prices. The Federal Reserves, as it seemingly always does, stepped in, promising to buy ETFs, which helped bring those two prices back in alignment.

The opposite of index investing is active management, which entails a portfolio manager or managers constructing a portfolio one security at a time. By dissecting the prospects of a company’s stock or bonds, the manager hopes to create a portfolio that can outperform the market and indexes.

Investing In Foreign Stocks and Bonds

Over the last ten years, however, $1 trillion of investors’ money has moved from active management to index investing. A big reason for this is that, during that same period, most active managers underperformed lower cost-index options.

Worse yet, during the Great Recession, when one hoped active management could reduce a portfolio’s losses (even though the S&P 500 Index lost approximately 50%), active managers did not perform a whole lot better, suffering losses similar or, in some cases, worse.

The significant long-term advantage of index investing is lower costs, as the fees charged to investors are significantly less than those in active management. This is because index investing has no managers to pay; no one is researching and picking the securities.

Portfolio Management Bigger or Smaller Accounts

However, what Buffett and Bogle fail to recognize—or, at the very least, acknowledge—is that those active managers trying to beat the market are what makes the market efficient: because of them, most individual securities get priced correctly. Thus, with no bargains for active managers to grab, investors might as well buy a lower-cost index.

Plus, with the Federal Reserve buying assets during market downturns, prices never get cheap enough for active managers to buy. Even Buffet, during this latest downturn, stepped back from buying after the Fed stabilized the markets. Buffet believed the Fed was doing the right thing.

So, while Buffett praises Bogle and indexing, he minimizes the importance of active management to the outperformance of indexing. Plus, if more investors switch to index investing, less research and active management will get done. This could create more bargains and set the stage for the investing world to flip back to benefitting from the security selection once highlighted by Buffett’s mentors, Benjamin Graham and David Dodd, in their famous 1934 book, Securities Analysis.

Sources:

Braham, Lewis. “A Seismic Shift is Happening, and Billions are Pouring Into These Index Funds and ETFs.” CNBC, April 17, 2017. http://www.cnbc.com/2017/04/17/a-seismic-shift-is-happening-and-billions-are-pouring-into-these-funds.html

Graham, Benjamin, and David L. Dodd. Security Analysis. Sixth Edition. Foreword by Warren E. Buffett. New York: McGraw Hill Education, 2008.

Levy, Rachael. “Warren Buffett Just Said This Man has Done the ‘Most for American Investors’.” Business Insider, February 25, 2017. http://www.businessinsider.com/warren-Buffett-praises-vanguards-jack-bogle-in-annual-letter-2017-2

“S&P 500 Companies by Weight.” SlickCharts. 2017. http://slickcharts.com/sp500

Light, Larry. “ Why Index Fund Creator Jack Bogle Hates ETFs.” Chief Investment Officer, January 17, 2019. https://www.ai-cio.com/news/index-fund-creator-jack-bogle-hated-etfs/

More About Tim

I will provide expert and highly personalized financial planning, retirement planning, and wealth management from my Boston office, when you need an independent financial advisor in Massachusetts (Greater Boston, North Shore, South Shore, South Coast, Merrimack Valley, MetroWest, or Rhode Island, Providence, Newport.)

These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice. 

 

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