By John Pantowich, Managing Director and Portfolio Manager
Over the years there has been no shortage of words written about Active versus Passive investing.
Active and Passive investing are two diametrically opposed approaches to managing investments. Most punditry focuses on the benefits and drawbacks of each, and why one is better than the other. At TAG, we believe that a mix of both active and passive investment strategies are an important part of a diversified portfolio.
This is hardly a novel perspective, but the reality remains that both active and passive investment strategies play important roles in delivering returns.
Active Investing
Active investing involves a hands-on approach by which professional portfolio managers select individual securities with the aim of outperforming a specific benchmark.
Portfolio managers will sometimes try to time the market for the right buying and selling opportunities based on market conditions, sector and economic outlook, and individual stock performance. If a manager believes that the stock market is heading for a downturn, they may sell a portion of their stock holdings and shift investments to safer assets like U.S. Treasuries or money market funds.
Active managers have the freedom to adjust their portfolios as needed. They can reduce exposure to sectors or stocks that are underperforming and overweight positions in securities that look more promising.
The benefits of active investing are flexibility — active managers can shift and pivot when opportunity presents itself. Additionally, the possibility of investment outperformance versus a benchmark over the long term makes active investing attractive.
Another potential advantage of active investment strategies is the possibility of an opportunistic strategy called tax loss harvesting. This process involves using losses from some investments to offset realized gains from others, reducing an investor’s tax liability.
For US investors, active managers are often preferable in the international equity asset class. These managers will have a deep understanding of local markets and economic conditions. They can leverage this knowledge to better position regional exposure as compared to the broad-based exposure required in the typical passive international index fund.
Since outperforming the market is such a difficult task, in our diligence we specifically target active managers that meet a number of criteria: well-established and larger firms; the manager and fund have at least a 10-year track record we can examine; and the managers consistently beat their benchmark. The active managers we use must meet those criteria.
Two examples are the WCM Focused International Growth Equity Fund and the Principal Midcap Equity Fund. Both have consistently outperformed their benchmarks.
For the previous 10 years (November 30, 2014 to November 30, 2024) the WCM Focused International Equity Fund has a 9.6% annualized rate of return net of fees compared to its benchmark (MSCI EAFE) return of 5.0% for the same time-period discussed above.
Similarly, the Principal Mid Cap Equity Fund has achieved a 13.2% annualized rate of return net of fees compared to its benchmark Russell Mid Cap Index return of 10.5% for the same time period.
Those are impressive numbers and examples of a highly successful active manager return.
The drawbacks of active strategies include higher fees than passive funds, along with the possibility of lower returns vs. a market benchmark. The inherent risk of active management is that human beings are smart and resourceful, but they’re also fallible. In fact, studies have shown that most active managers tend to underperform their benchmarks.
Data from a 2020 Morningstar study indicated that more than 60% of active U.S. stock fund managers underperformed their benchmark over a 10-year period.
Passive Investing
Passive investing involves replicating the performance of a market index, such as the S&P 500, utilizing index funds or exchange-traded funds (ETFs) that track the index. The goal of passive investing is not to beat the market but to match the market, with lower costs than active management.
Since passive investment funds simply track an index, they can be managed with very low costs and minimal management. Fees are typically in the range of 0.05-0.25% of assets compared to 1% for many actively managed funds.
Index funds are straightforward products. Investors know exactly which stocks or bonds are part of the fund since they track a publicized index. There is no complex investment strategy or management philosophy.
Whichever market or sector an investor wants exposure to, there’s an index and index fund that can track it. The fund will do exactly that without any decision-making by the investor and without any risk of style drift or overconcentration by the portfolio manager.
There’s no beating the market with an index fund. Your long term results are intended to mirror the market.
Typically, an investor might prefer a passive manager in highly efficient markets like U.S. Large Cap Blend where research is abundant and readily available to all.
Two examples are the Vanguard 500 Equity Index Fund and the Vanguard Small Cap Equity Index Fund.
Vanguard 500 Equity Index Fund is in the category of Large Blend and tracks the S&P 500 Index. For the previous 10 years (November 30, 2014 to November 30, 2024), the fund returned 13.3% annualized net of fees. Its peers in the Large Blend category (which includes both active and passive funds) have an average return of 11.8% for the same time period.
In the Small Blend category we sometimes use the Vanguard Small Cap Equity Index Fund. This index fund tracks the CRSP US Small Cap Index. For the previous 10 years this fund has achieved a 10.0% annualized rate of return net of fees compared to its small blend category peers that had an average return of 8.9% for the same time period
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Active investment strategies offer flexibility and the ability to beat the market net of fees. Our rigorous investment due diligence allows us to evaluate funds on many levels and make strong assessments about a manager’s ability to outperform the market.
At the same time, passive investing offers more predictable, market-matching returns with much lower fees. We believe in combining both active and passive investment strategies to achieve our clients’ investment goals and preserve their wealth for generations.