Active versus Passive Investing

Historically, mutual funds were the most popular investment fund type in the United States, as explained in our educational article investment fund types. Historically, most mutual funds have been actively managed, which means that the mutual fund has a portfolio manager or managers who judgmentally decide what investments to make, within certain broad guidelines laid out by the mutual fund's investment charter and/or board of directors.

In the mid 1970's, the first mutual funds were launched that tracked an index rather than being actively managed by a portfolio manager. One of the early index mutual funds was started by John Bogle, who founded Vanguard. John Bogle and Vanguard have since transformed the investing world with the success of Vanguard's index based mutual funds and later with the success of Vanguard's low cost ETFs.

However, for most of the last thirty years, actively managed mutual funds remained the most popular type of investment fund in the U.S. But as each year has gone by, more and more investors have come to believe in the merits of index, or passive investing. And more and more index mutual funds have been launched. As of July 21, 2017, TD Ameritrade's mutual fund screener showed that there were 1,156 index mutual funds, out of a total of 26,097 mutual funds in their database, or just over 4%.

The growth in the ETF industry has been largely fueled by the trend towards passive investing. ETFs have became synonymous with passive investing because most ETFs today track an index:

Investment StyleETF Count
Actively managed322
Buys and sells commodity futures on a set pattern11
Follows a set investment pattern3
Passively tracks an index1,888
Physically owns a precious metal13
Tracks price of currency exchange rates12

SPIVA Report

The growing trend towards passive investing has been driven by the mounting evidence that most actively managed mutual funds don't perform very well. For the past 15 years or so, S&P has published an annual study comparing the performance of actively managed funds versus their respective benchmarks. This report is called the S&P Indices Versus Active Funds report, or "SPIVA report", and it has consistently shown that most actively managed funds underperform compared to their respective benchmarks.

For the 2016 SPIVA Report , S&P added a new set of data where they compared the performance of the actively managed funds over an even longer time period of 15 years. The result was the same:

Over the 15-year period ending Dec. 2016, 92.15% of large-cap, 95.4% of mid-cap, and 93.21% of small-cap managers trailed their respective benchmarks.

Why is active management so difficult?

There are a variety of reasons that actively managed mutual funds have performed so poorly. First and foremost is that most actively managed mutual funds charge investors very high management fees. So even if a portfolio manager is able to successfully outperform his or her benchmark, the outperformance is usually not significant enough to offset the high management fees. So the odds are stacked against the portfolio manager.

ETFs, on the other hand, usually contain much lower fees. As of today, there are 761 U.S. stock market ETFs that track an index, and they have an average expense ratio of 0.45%. That is much lower than the fees of a typical actively managed mutual fund.

Another reason for the poor performance of many actively managed mutual funds is that many portfolio managers end up being "closet indexers". A closet indexer is a portfolio manager who builds a portfolio that is very similar to that of the index the portfolio manager is trying to beat. In order to justify the high management fees, a portfolio manager has to significantly outperform his benchmark index. To do that, you have to build a portfolio that is significantly different than the index. Sometimes, that is tough to do, especially if you are managing a large amount of money and you own 400 or 500 stocks.

To really outperform the market, you have to take risks, and own a portfolio that is significantly different than the market as a whole. Or you have to own a really concentrated portfolio of just a handful of stocks, which many portfolio managers are reluctant to do. So it is a challenge to outperform the market, year after year.

All data is a live query from our database. The wording was last updated: 11/11/2017.

2020 © Stock Market MBA, Inc. Terms of use | Privacy policy