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Passive or active investment. What is the best choice?


As one famous western says, there are two types of people in the world – and in our case, two types of investors – active and passive. These are two opposing camps that constantly argue about the advantages and disadvantages of one or another approach. And in this article we will try to figure out which approach is wiser to choose. But first, let’s define the concepts.

What are active and passive investments, and what is the difference between them?

Benjamin Graham in his book “The Intelligent Investor” gives the following characteristics:

A passive investor primarily seeks to avoid serious mistakes and losses. In addition, he wants to be relieved of the difficulties and worries associated with the need to constantly make decisions. The main difference between an active investor is that he spends his time and effort on choosing the most reliable and attractive securities. For decades, the active investor could be confident that his additional efforts and skills would be rewarded with higher average returns than the passive investor’s. Today we have to doubt this. But in a year or more, everything may change.

If I were trying to characterize passive and active investors, I would describe them as follows:

Active investors are engaged in trying to select certain asset classes and individual securities in their portfolio based on their potential return and risk, trying to find what in their opinion is more attractive in these parameters. In addition to the selection of securities, they are also engaged in the selection of favorable moments in time to complete their transactions – in other words, they use market taming. The main goal of an active investor’s actions is to get a return above the market index.

Passive investors use the strategy of passive portfolio investments, deliberately refuse to select individual securities and to choose the moments for making transactions. Since they believe that the chances of beating the market index are minimal in the long term, it is much more reasonable to simply invest in the index. Therefore, their portfolio consists mainly of index funds. And as you will see later, statistics are on their side.

Is it better to be an active or passive investor?

First, let’s turn to statistics. One of the divisions of S&P Dow Jones Indices publishes statistics on actively managed funds in different countries on its website. According to their research, over the past 5 years, 80.6% of US equity funds have shown returns less than the return on the S&P 500. Over the past 3 years – 71.13%. Over the past year 70.98%. Statistics for other countries are roughly similar.

Thus, it turns out that the overwhelming majority of actively managed investment funds are losing out to the index.

spiva statistics on active management funds

Source: https://www.spindices.com/spiva

This information gradually reaches investors, and more and more of them come to the conclusion that investing in index funds is more profitable. Therefore, over the past 10 years, the amount of assets in index funds equaled the amount of assets in actively managed funds. Investor money is slowly but surely flowing into index funds.

The amount of assets managed by index funds has been growing for the past 10 years

However, despite the fact that most of the managed funds lose out to the index, still a certain percentage of funds outperform it. Perhaps these funds are managed by talented professionals, and it is enough to simply invest in such a fund to overtake the index?

Leaders don’t stay leaders

Other studies tell us that there is no stability in such results. For the study, we took all actively-managed US equity funds and divided them into four quartiles based on last year’s returns – 25% best, 25% above average, 25% below average, and 25% worst. We then looked to see if these funds remained in their quartiles based on the next three years’ performance.

If the best funds consistently showed their high returns, they would remain in their quartile (Quartile 1). In this case, in the cells highlighted in gray, the figure would be at least 25%. However, in reality, the best funds in the next three years were more likely to be among the funds with lower returns.

Source: http://people.stern.nyu.edu/adamodar/pdfiles/blog/activeinvesting.pdf

Super managers at one time

Other research shows us the performance of super-managers relative to the S&P 500 over the next two years after being named Manager of the Year by Morningstar. As you can see from the graph, in the next two years almost no manager was able to repeat the previous result – almost all of them “rolled down”.

Thus, those actively managed funds that have shown excellent results in the past, in most cases, cannot repeat them in the future. This means that it is useless to focus on the results of the past when choosing funds.

Buffett vs. Hedge Funds

Another striking example in favor of passive investments. In 2007, Warren Buffett, perhaps the most famous active investor in the world, offered to make a bet with anyone that no professional could build a portfolio of at least five hedge fund funds, which in ten years will overtake the one of his chosen in terms of profitability. an index fund for the S&P 500 index, including all commissions and fees.

Managing director Ted Sides from investment firm Protege Partners responded to the offer. He selected five funds of funds, which in turn invested in a total of 100 hedge funds (this is the type of funds that have the most money-making opportunities).

After 10 years – December 31, 2017, the bet expired. The results were as follows – the Vanguard index fund, which Buffett chose, grew by 125.8%. The best of the hedge funds (their names were not disclosed) rose 87.7%.

Buffett's bets against hedge funds

Buffett bet results

With this bet, Warren Buffett wanted to show that the hedge fund industry has very high fees, and the funds act more in the interests of the management team, and not in the interests of ordinary investors. While hedge funds typically charge 2% per annum for asset management and 20% of profits, if any, the Vanguard Index Fund only charges their clients 0.04% in fees. High commissions of actively managed funds are one of the main reasons for their poor performance.

Can a simple private investor overtake the market?

But maybe an ordinary private investor who selects shares in his portfolio himself can beat the market? Unlike an investment fund, it does not have to pay large management fees to anyone. And he also does not need to comply with legal restrictions that exist for funds, and which managers must strictly observe. And there is no need to keep some of the assets in cash, as funds have to do for operational reasons. And there is no need to sell the portfolio when the market falls, when too timid investors run from the fund. The capital of a private investor is small, which means that you can easily enter into low-liquid assets, and so on.

Super Investor Strategy

You can also use the super investor strategy to achieve super results. In 1984, Warren Buffett wrote an essay titled Superinvestors from Graham and Dodd Village. In his essay, Buffett, using the outstanding performance of some managers, showed that you can beat the market.

As an example, he selected the results of Walter Schloss, Tom Knapp, William Rouen, his partnership and a number of other managers. All of them were able to significantly outperform the stock market index for a long time. All of these managers had one thing in common – they were either Ben Graham’s students or used his value approach. Although each worked independently of the others and invested in different stocks.

superinvestors

Source: https://en.wikipedia.org/wiki/The_Superinvestors_of_Graham-and-Doddsville

These results are difficult to dispute. But you need to pay attention to when they were received. This is 1950-1980. And Ben Graham worked even earlier – from the 1920s. We need to remember what those times were. Then there were no computers, there was no YahooFinance and Bloomberg, there was no online trading. Information about companies and promotions spread slowly – through newspapers, directories, and the telegraph (later radio and TV). It was not uncommon that in order to get to know the company well, you had to go to its office. The information that made it possible to find underestimated companies was not available to everyone or had to work hard to get it. And those who made the effort to do this received their advantage and could make money on it.

Today, in the era of the media, the Internet, openness and global informatization, all the necessary information – quotes, reporting, multipliers, news – is literally two clicks away from the investor. All available information is much faster reflected in the market price, which means that the efficiency of the markets is much higher than before. In order to stay ahead of the market, you still need to have the advantage of finding market inefficiencies. But today they are even more difficult to find.

Most stocks are worse than the market

There is one more difficulty that an active investor will have to overcome – most stocks in the index … lose to the index. A few years ago, JP Morgan Asset Management conducted a survey of the Russel 3000 Index, the American index of large, medium and small cap stocks. They took the period from 1980 to 2014, and analyzed the lifetime returns of about 13,000 shares from the moment when the security was included in the index until the end of 2014 or until its last quotation (when the security ceased circulation as a result of a merger or was excluded from the index ).

The following diagram shows the results:

  • the return on the median stock is 53% worse than the return on the index;
  • two-thirds of the stocks performed worse than the index, and 40% of the stocks had negative returns since they were included in the index;
  • the share of super-winners who grew by 500% or more (to the right of the green line) is only about 7% of the total.
why is it difficult to beat the stock index

Source: https://www.chase.com/content/dam/privatebanking/en/mobile/documents/eotm/eotm_2014_09_02_agonyescstasy.pdf

From the diagram, you can see that there are significantly more stocks to the left of the black line, which denotes 0% (index return), than to the right, where stocks that surpassed the index return are displayed. But a logical question may arise – why in such a situation does the index grow at all? The fact is that the loss of a stock is limited to 100%, and the profit can reach 1000% and even more. These shares are just “dragging” the index up.

Another study shows the percentage of stocks that have outperformed index returns in a 10-year rolling period since 1973. The average number of stocks to outperform the index over 10-year periods was about 43%. Very rarely, this number exceeded 50%. In only 22% of 10-year periods, the number of stocks that surpassed the S&P 500 exceeded half.

Source: https://awealthofcommonsense.com/2019/03/how-often-is-it-a-stock-pickers-market/

Thus, more than half of the stocks turn out to be worse than the index in terms of profitability, which makes life even more difficult for those who choose stocks.

So which is the best choice?

Which strategy to choose passive or active – everyone must decide for himself. On the side of passive investing, you are guaranteed to get market returns (of course, minus very small commissions and taxes), and this strategy will take a minimum of your time.

On the side of active management, in theory you can overtake the market, but your chances of doing so in the long run are slim. In addition, you will first have to spend a lot of time studying the analysis of stocks, and then regularly and on an ongoing basis to analyze securities. It is unlikely that an ordinary person wants to do this. This strategy is more suitable for addicted people.

Until now, a lot of people argue about which is better – passive or active investment. But few people remember that the ultimate goal of an investor is not to outstrip the market, but to achieve their financial goals. And you don’t have to compete with the market for this.

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Polak Donovan
About author

Hello! My name is Polak Donovan, I am a private investor, I have been trading currencies in Forex since 2011, I have increased my capital by 70% with growing dynamics. During this time, I have accumulated a lot of experience that I would like to share in my blog. I will tell you how to speculate in the market and at the same time reduce the beginner's mistakes. I will show my results and share my predictions, I also collected the most relevant news for you on the site, which, in my opinion, affect market trends.
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