Active vs. Passive Investment Management

Investing is a personal thing that can be really rewarding if you do it right. But what does “doing it right” mean? Is there really a “right” way? And how do you even get started if you’re considering investing in a new asset class or method of investing?

In this article, we’ll tackle the basics of Active and Passive Investment Management so that you can make an informed decision about what kind of investor you are—and maybe even change your mind about whether investing is right for you.

Get To Know Mutual Funds

Mutual funds—which are simply collections of different investments like stocks or bonds—are often considered the simplest and best way for most people to invest. But, as we’ve seen, fund managers fail to beat the market 75 percent of the time, and it can be hard to tell which funds will actually perform well over the long term. And no matter how good a mutual fund is, the returns are hampered by the large fees they charge. (Sure, there are some low-cost mutual funds, but because of the way they compensate their own portfolio managers and other employees, it’s virtually impossible for them to compete with the low costs of passively managed index funds, which I’ll talk more about in a minute.)

When it comes to investing, fees are a huge drag on your returns. This is a little counterintuitive, since we’re used to paying for service, like our gym membership or admission to Disneyland. If we’re getting something out of it, we should pay a fair price, right? The key is “fair,” and many of the financial “experts” we turn to for guidance make an effort to squeeze every last cent out of us.

I signed  up  for  this retirement  fund    that charged a lot for management and now I have to put in money every  month  for five years to get it out. At the    time, I was convinced by the financial adviser’s demeanor and fancywords. I am debating whether I should get the money out with a $1,000 loss for the cancellation fees. I feel like such an idiot for signing up for a dumb fund with a crazy fee like this.

—SUNG WOO KIM, 28

Active Investment Management And Mutual Funds

You see, mutual funds use something called “active management.” This means a portfolio manager actively tries to pick the best stocks and give you the best return. Sounds good, right? But even with all the fancy analysts and technology they employ, portfolio managers still make fundamentally human mistakes, like selling too quickly, trading too much, and making rash guesses. These fund managers trade frequently so they can show short-term results to their shareholders and prove they’re doing something—anything!—to earn your money. Not only do they usually fail to beat the market, but they charge a fee to do this. Mutual funds typically charge 1 to 2 percent of assets managed each year. (This percentage is known as a fund’s expense ratio.) In other words, with a 2 percent expense ratio and a $10,000 portfolio, you’d pay $200 per year in fees. Some funds even tack on additional sales charges, or “loads,” to the purchase price (a front-end load) or sales price (back-end load) of the fund. These are just some of the tricky ways mutual fund managers make money whether they perform or not.

Passive Investment Management and Index Funds

Two percent doesn’t sound like much until you compare it with the alternative: “passive management.” This is how index funds (a cousin of mutual funds) are run. These funds work by replacing portfolio managers with computers. The computers don’t attempt to find the hottest stock. They simply and methodically pick the same stocks that an index holds—for example, the five hundred stocks in the S&P 500—in an attempt to match the market. (An index is a way to measure part of the stock market. For example, the NASDAQ index represents certain technology stocks, while the S&P 500 represents five hundred large US stocks. There are international indexes and even retail indexes.)

Most index funds stay close to the market (or to the segment of the market they represent). Just as the stock market may fall 10 percent one year and gain 18 percent the next year, index funds will rise and fall with the indexes they track. The big difference is in fees: Index funds have lower fees than mutual funds, because there’s no expensive staff to pay. Vanguard’s S&P 500 index fund, for example, has an expense ratio of 0.14 percent.

Different Types of Index Funds

Remember, there are all kinds of index funds. International funds, healthcare funds, small-cap funds. There are even funds that match the overall US stock market, which means if the market goes down, these index funds will also go down. But over the long term, the overall stock market has consistently returned about 8 percent after inflation.

Let’s look at the performance from two sides: the downside (fees) and the upside (returns). First, let’s compare the fees for a passively managed fund with those for an actively managed fund.

Passively Managed Fund vs Actively Managed Fund

Assuming an 8% return on an investment of $100/month	Passively managed index fund (0.14% expense ratio)	Actively managed mutual fund (1% expense ratio)	Investment pays much more fees on an actively managed fund
After 5 years you have…	$7,320.93	$7,159.29	$161.6
After 10 years you have…	$18,152.41	$17,308.48	$843.9
After 25 years you have…	$92,967.06	$81,007.17	$11,950

Now let me show you how these numbers change at higher levels. Remember: What seems like a small fee actually turns into a huge drag on your performance. This time, assume you put $5,000 into an account and you add $1,000 a month, with the same 8 percent return.

After 5 years you have…	$80,606.95	$78,681.03	$1,925.92
After 10 years you have…	$92,469.03	$183,133.11	$9,335.92
After 25 years you have…	$965,117.31	$838,698.78	$126,418.53

John Bogle, the Vanguard founder, once shared a shocking example with PBS documentary series Frontline. Let’s assume you and your friend Michelle each invested in funds with identical performance over fifty years. The only difference is that you paid 2 percent lower fees than she did. So your investment returned 7 percent annually, while hers returned 5 percent. What would the difference be?

On the surface, 2 percent in fees doesn’t seem like much. It’s natural to guess that your returns might differ by 2 percent or even 5 percent. But the math of compounding will shock you.

“Assuming a fifty-year horizon, the second portfolio would have lost 63 percent of its potential returns to fees,” Mr. Bogle said.

#1 Enemy in Investing: FEES

Think about that. A simple 2 percent in fees can cost you over half of your investment returns.

Or that 1 percent fee. One percent can’t be that much, right? For the same fifty-year time period, that fee will cost you 39 percent of your returns. I know, I know. Maybe fifty years is too long to think about. Let’s try a thirty five-year outlook. What would a 1 percent fee cost you? Try a 28 percent reduction in your retirement returns, according to the Department of Labor.

This is why I’m so fanatical about reducing fees. In investing, fees are your enemy.

If your decision was determined by fees alone, index funds would be the clear choice. But let’s also consider another important factor: returns.

Just  before I got married I decided to speak  to  a  financial adviser. I wanted to get a good picture of my position before I merged my financial life with my husband’s. His fee wasn’t ridiculous compared to the top of the market, but the advice certainly was, scaring me into buying managed products (with ongoing fees) I didn’t need. It made my financial position seem more complex than it actually was, and I still had no idea of what to do. While on honeymoon  I  read  I Will Teach You to Be Rich for the first time, and when I got back, I reversed  most  of  the decisions the financial adviser had made.

—LUCINDA B., 33

Another Factor to Consider: Returns

Despite my hammering home the fact that mutual funds fail to beat the market 75 percent of the time, I will say that they do occasionally provide great returns. In some years, some mutual funds do extraordinarily well and far outperform index funds. In a good year, for example, a fund focused on Indian stocks might return 70 percent—but one or two years of great performance only gets you so far. What you really want is solid, long-term returns. So, if you’re thinking about using a broker or actively managed fund, call them and ask them a simple, point-blank question: “What were your after-tax, after-fee returns for the last ten, fifteen, and twenty years?” Yes, their response must include all fees and taxes. Yes, the return period must be at least ten years, because the last five years of any time period are too volatile to matter. And yes, I promise they won’t give you a straight answer, because that would be admitting that they didn’t beat the market consistently.

It’s that hard to do.

So, the safe assumption is that actively managed funds will too often fail to beat or match the market. In other words, if the market returns 8 percent, actively managed funds won’t return at least 8 percent more than three-fourths of the time. In addition, when combined with their high expense ratios, actively managed funds have to outperform cheaper, passively managed funds by at least 1 to 2 percent just to break even with them—and that simply doesn’t happen.

The Bottom Line:

There’s no reason to pay exorbitant fees for active management when you could do better, for cheaper, on your own. Yet you and I know that money isn’t purely rational—even seeing the clear math here. It’s emotional. So once and for all, let’s tackle the invisible money scripts that keep people believing that active investment is worth it—then we can start investing.

Active vs. Passive Investment Management is a post from: I Will Teach You To Be Rich.

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