You don't often meet people who admit to taking a passive approach to life, especially in Boulder County, which is home to entrepreneurs and Uber athletes. The word “passive” connotes listless days at the beach, apathy, and an overall lack of energy. Active, on the other hand, represents diligence, insight, and dynamism. Active and passive can not only be used as words to describe human behavior, but can also be used to categorize investment approaches.
When applied to mutual funds and exchange-traded funds (ETFs), we start with the idea that active investors can beat the market. And active investors come in all shapes and sizes. For example, your neighbor who has a hunch about a stock may be an active investor and also a sophisticated person with a process for selecting stocks that they think will perform better than their peers. It is also possible that the company is a privately held investment company. Active managers aim to outperform the market through fundamental analysis of a particular company's future profitability and growth. Passive investment managers, on the other hand, typically have a target index and seek to reflect that by purchasing stocks within that index. Perhaps the oldest example of this is the Vanguard 500 fund. Vanguard doesn't try to pick the best large company stocks with this fund. Instead, they do their best to invest most of their capital into these 500 stocks every trading day.
Each year, S&P Dow Jones Indices creates the SPIVA Scorecard, which analyzes the performance of thousands of actively and passively managed investments in a variety of categories, including large U.S. corporate stocks. Last year's report hasn't been released yet, but if it's similar to past years, the conclusions will likely be the same. In any given year, most active managers tend to underperform the indexes that are appropriate for their mutual funds or his ETFs. Active managers' performance uniformly worsens over longer time horizons.
The SPIVA Interim Report, released on June 20, 2023, showed that 60% of active U.S. large company funds underperformed the S&P 500 over a six-month period. Perhaps even more surprising is that the report also looks at past performance. We found that the most active manager outperformed his S&P 500 in just 3 of the past 23 years.
This record records an underperforming compound that is remarkably stable over a long period of time. Over the past three years, his 80% of active funds in this category have underperformed the benchmark. Looking back 15 years, his 92% of active managers underperformed the index. This poor performance is not limited to stocks of large American companies. In fact, he found no single U.S. investment category where most active managers outperformed the index over his 10-year period.
Why does active management perform so much worse than passive management? Investment cost is probably the most important factor. Passively managed funds are low-cost by their nature, with some funds having annual fees of less than his 0.04%. Actively managed funds have higher operating costs. You need to hire managers with good qualifications who can build your brand as a good stock picker. Managers often hire analysts to find companies that outperform their peers. If a fund has a promising track record, the fund company will spend a lot of money on marketing. They also incur the cost of buying and selling individual stocks much more frequently than passively managed funds. It can also be difficult for an active manager to invest nearly 100% of his fund in stocks because “good ideas” do not appear every quarter.
Being an active fund manager is tough. It's not enough that the stocks they pick perform as well as the index. To overcome an inherently high cost structure, we must consistently outperform the index. While it's true that there are a few managers who have had above-average performance over long periods of time, their above-performance performance can be fickle. Many star coaches have fallen below mediocrity after promising starts. Overall, passively managed funds are likely to have an advantage.
David Gardner is a Certified Financial Planner
