Active versus Passive Investment

Investors who believe in the efficient market hypothesis would argue on behalf of the passive investment style. If stock prices reflect all relevant information and stocks are always priced at their intrinsic values, it would be difficult for investors to beat the markets over long periods. Consequently, if investors cannot profit from insider information and there are no undervalued stocks, they have two alternatives: (1) invest in market indexes or (2) choose individual stocks and hold them for long periods. These are known as buy-and-hold strategies.

Table 13-1
Asset Allocation of Stocks by Style


Indexing
Those who subscribe to index investing believe that events affecting companies occur randomly. Therefore, investors have a 50–50 chance of being correct in picking stocks that will go up; hence their odds of beating the market become more muted. Consequently, these investors are satisfied with the returns of the market and would invest in the stocks that make up the market indexes. This strategy can be achieved in the following ways:
* Investing in the individual stocks in the index, for example, the 30 stocks in the DJIA. However, investing in the 500 stocks of the Standard & Poor’s (S&P) 500 Index is not practical for most individual portfolios. Investors could invest more easily in sectors of the S&P 500 Index, such as the technology sector or the financial sector, or the “nifty fifty” stocks, or the Dogs of the Dow.
* Investing in index-tracking stocks (exchange-traded funds), which underlie the indexes. Examples of these are the SPDRs, which track the S&P 500 Index and the sector SPDRs of the S&P 500 Index; the DIAMONDs, which track the DJIA; and the Nasdaq 100 tracking stock, which invests in the largest 100 companies in the Nasdaq.
* Investing in index mutual funds.

An examination of the results of index mutual funds versus the actively managed mutual funds, as a proxy of passive versus active investing, makes the case for indexing more compelling. Tergesen (1999, p. 110) reported that the average S&P 500 Index mutual fund earned around 18 percent annually over the 10-year period 1989–1999 as compared with 16 percent annually for the actively managed equity mutual funds. This 2 percent annual difference may not seem all that significant, but when this difference is compounded over time, the results point overwhelmingly toward indexing. Over a 10-year period, the compounded returns of index funds exceeded those of actively managed equity funds by about 80 percent (Tergesen, 1999, p. 110). More recently, according to Burton Malkiel, a finance professor at Princeton University, the S&P 500 benchmark index fund outperformed 84 percent of actively managed large-cap funds during the 10-year period 1993–2003 (Farrell, 2003).

There are a number of reasons to explain the advantages of indexing over actively managed mutual funds:
1. Actively managed mutual funds may keep some money in cash, anticipating a downturn in the market. If this does not materialize, then index funds will earn more from their holdings because they are always fully invested.
2. The annual expense ratios of index funds are considerably lower than those of their actively managed equity mutual fund counterparts. Index funds do not change their holdings unless the stocks in the indexes are changed. Actively managed funds can experience high turnovers of their holdings, which means higher transaction costs.
3. Large-cap stocks, which are followed by many analysts, are probably efficiently priced, which gives index funds an advantage over the stock picker.

The opportunities for active managers and stock pickers are in the small-cap and international stocks, which may be underfollowed by the analysts. Similarly, in a market downturn, active managers can put limits on the decrease in their funds’ stock prices by raising cash or investing in defensive stocks, which may not go down as much as the fixed portfolios of the index funds. This is not to say that actively managed portfolios will not go down in a bear market. These portfolios will go down just like the index funds, but steps can be taken to reduce the amount of the decline in their value. This can be seen where small-cap equity managers have outpaced the Russell 2000 Index by including some large-cap stocks in their holdings. Other studies confirm that active managers do not consistently outperform indexing (Martin, 1993, pp. 17–20).

Buy-and-Hold Investing
Besides indexing, the other passive investment strategy for stock pickers is to buy stocks for the long term and hold them. In other words, investors would hold these stocks, making minimal changes over time. Performance between active and passive strategies is more difficult to evaluate because this depends on the composition of the stocks in both active and passive portfolios. However, using index funds as the basis for buy-and-hold investing, the results confirm that active portfolio managers do not outperform the buy-and-hold strategy. Jensen (1968, pp. 389–416) surveyed 115 mutual fund managers during the period 1945–1964 and found that the average returns of these funds were less than investments in a portfolio of Treasury bills and the market index would have returned.

Market timers often tout how they were able to exit the market successfully before a crash and then reenter the market at a lower point to increase their overall returns. This may be easier said than done. Research done by T Rowe Price showed that in order to do better than a buy-and-hold investor, market timers would need to be accurate in more than 70 percent of their calls to enter and exit the market. A study done by Nejat Seyhun covering the period 1963–1993 found that an investor who exited the market for just 1.2 percent of the market’s best-performing days would have lost out on 95 percent of the total returns (Strong, 1998, p. 363).

There certainly appears to be a disconnect between the research results as reported from the ivory towers of academia and the communications and hype as reported from many people on Wall Street. The growth of newsletters forecasting the precise future movements of the markets and how to time them is on the rise as more investors enter the stock markets hoping to double or treble their money over a short period. As of this writing, the clairvoyant with 100 percent accuracy in calling the markets has yet to emerge. Until such time, the odds are stacked against timing the markets; they favor the buy-and-hold investor.

What becomes apparent is that it is difficult to beat the markets consistently over long periods regardless of the method. This theory certainly lends support for buy-and-hold strategies over market timers. In addition to those reasons already discussed, several reasons put forth for the underperformance of active investing over passive investing include
* Active trading means higher transaction (commission) costs.
* If the holding period for stocks is less than one year, the gains incurred are taxed at higher Federal tax rates than those of the longer-term holding periods of the buy-and-hold investors.

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