“Active is better than passive.” “Passive is better than active.” “Both approaches work.” If you’re not quite sure you understand what those statements mean (or why you should care), don’t worry, you’re not alone.

Before I get too far into the discussion, I want to highlight that the purpose of this series of blog posts is not to add to the already massive number of studies, whitepapers, presentations, academic papers, blogs, etc. that attempt to prove which overriding type of investment product, “active” or “passive,” is “better.” Furthermore, I am not going to give you my opinion on which product type is superior. Rather, my primary goals are to better define what is being debated, spend time on what I do not believe has been discussed nearly enough during the “active vs. passive” debate and lastly, in instances where an investor has hired a financial professional to manage money on their behalf, provide investors with a framework for questioning that person to better understand the strategy they use to invest client assets. To summarize my goal for you in three words: Understand. Educate. Question.

Investment topics such as these are important to understand because I believe investors need to be knowledgeable. And if an investor hires someone to manage their money, and pays them for that advice, that investor needs to feel confident that the financial professional they have chosen actually knows what they’re doing. This includes the individual having a clear understanding of what their personal limitations and strengths may be. One person cannot excel at every position on the baseball field. Similarly, issues arise when individuals believe they excel at all facets of investment management. Ego instead of self-awareness takes hold. So, it is important that each fiduciary knows what they do know and also know what they don’t, and then focus on their areas of strength. As the father of modern game theory, John von Neumann stated, “There’s no sense in being precise when you don’t even know what you’re talking about.” With that in mind, I’ll begin with two important definitions before we dive into a brief discussion on active vs. passive, followed by a more detailed discussion on passive.

What is a passive investment?

A passive investment is often associated with investable index mutual funds or exchange-traded funds that mirror a given market index. It is a style of management where a predetermined basket of securities are purchased and automatic adjustments are made with no personal judgement or forecasting.

What is an active investment?

An active investment is often associated with mutual funds whose manager(s) attempts to beat a stated market index through various means, such as through individual stock selection or by investment in specific sectors or industries. It is a style of management where active decisions are made based on a manager’s forecasts for individual companies, sectors and industries and/or other factors.

Active vs. Passive

As I mentioned earlier, there have been a significant number of “active,” and “passive” papers written that attempt to prove why utilizing one strategy, or both strategies in combination, are superior. Most of these papers have been written by intelligent individuals that have well-thought out views and data to support those views. In aggregate, these papers are helpful. However, in my opinion, problems arise for two reasons.

The first is that there does not appear to be a broad understanding of what is actually being debated in these papers. Readers get too caught up in the analysis laid out in the paper and then “miss the forest for the trees.” Oftentimes this occurs because most of the research papers on active vs. passive only address one piece of the entire puzzle: how all active mutual funds perform vs. a handful of market indices. Again, in isolation these are very interesting studies. However, in my opinion, this type of exercise completely misses the point. Every team in professional sports does not make the playoffs. Every Olympic athlete does not get a gold medal. There are winners and losers. And the fact is that some active mutual funds will outperform market indices over the long term.

However, another fact is that many do not. Many actively managed products will consistently disappoint investors for a variety of reasons including, but not limited to: they are not managed by particularly talented portfolio managers; the fees associated with the products are too expensive; excessive trading significantly increases “hidden” trading costs; or the portfolio manager does not have the investment discipline to focus on the long term – impatience and other behavioral pitfalls take over. The challenge for investors is to be able to distinguish the perennial laggards from the actively managed investment products that at least have the foundation for potential investment success over the long term (i.e. we define long term as a complete market cycle).

The second problem arises because more often than not, investors latch on to the outcome of only one of the aforementioned papers (or only a couple of sentences from a paper) and then apply the outcome of that one study to an entire data set over an entire timeframe. The end result is that misinformation, or at least less than accurate information, is disseminated as fact. And herein lies my fear — that the industry has moved investors away from homework and education in the search for an easy answer. Unfortunately, there are no easy answers. As an investor, you owe it to yourself, and we to our clients, to do our homework. This means educating yourself on important topics, or educating yourself on how to effectively interview someone that you will hire to invest on your behalf, so that you can feel more comfortable that the individual chosen understands these complex issues with active and passive investing.

My next post will focus on passive investments and passive investing.

Charles J. Batchelor is Director of Investment Research at Cleary Gull

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www.clearygull.com