Monday, July 18, 2016

Why Passive Fund Management Outperforms Active Fund Management

Why Passive Fund Management Outperforms Active Fund Management

In my most recent post I made a broad ten-thousand-foot-level argument as to why making frequent changes to an investment portfolio – whether in reaction to or in anticipation of what the stock market/economy might do – is destructive behavior.

Today, I would like to get a little more technical and specific, because I believe this is such a serious issue that is the main driver in determining whether you’ll see tangible results from your years of hard work and investing or you’ll end up otherwise, without anything to show for your efforts.

Active vs. Passive Management

One of the main choices you must make as an investor is deciding the manner in which you want your portfolio to be managed: actively or passively. In active management, a mutual fund manager attempts to predict what will happen next and which stocks/bonds are going to win, so to speak. This is called active management because it involves constantly selling and buying stocks/bonds and changing things up in an attempt to “beat” the market. Personally, I don’t support this form of investing because in order for it to work, you’d need a fund manager who could actually precisely predict what the markets will do in the future. Common sense tells me that’s impossible. But let’s just leave it at that for the moment.

The alternative is passive management which, in contrast, understands that since the market’s movements are random and unpredictable, the most effective thing to do is to invest in an entire asset class/index and leave the investments alone. The goal of this approach is to capture/duplicate the market’s returns, not attempt to beat it, as in the case of actively managed funds. 

Now let’s get back to the argument at stake. Is constantly trying to make changes to a portfolio based on day-to-day events (active management) really destructive for your investments?

The independent investment research firm Morningstar publishes a report called Active/Passive Barometer, which gives us a glimpse of how these two opposite approaches at managing investments hold up against each other. Here is a quote from the report’s executive summary:

…The report finds that actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons, and experienced high mortality rates (that is, many are merged or closed)…
Now here’s my humble opinion: Attempting to actively manage investments hasn’t worked so far, which should not be surprising at all. Human beings cannot predict the day-by-day movements of a completely random and unpredictable market. As the report found, not only are these active funds failing miserably, but they also have “high mortality rates” – they have such bad results that they end up closing.
Think about it and invest your money prudently. My very best to you.

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