The ‘Active vs. Passive’ debate has long been one of the most contentious topics among investors. Advocates of active investing believe (strongly!) that hand-picking individual stocks in a portfolio is the only way to go. In contrast, those who subscribe to a passive investing model believe (just as strongly!) that the best path to growth is investing in a large group of diverse stocks and then relying on the law of large numbers to drive growth. But what if I told you there was a third option—one that combines the best of both of these approaches to provide a more balanced approach to investing?
It’s intriguing, right? But before we go there, let’s start with a little investing 101. The Active vs. Passive debate is complicated, and unraveling the two requires some understanding of how each approach is executed.
What is ‘passive investing’?
At the highest level, ‘passive investing’ is a buy-and-hold strategy that relies on minimal trading and usually aims for long-term growth. The most popular passive funds track the S&P 500 index—a group of stocks that includes, with a few exceptions, the 500 largest stocks in the United States. As a result, these funds hold larger amounts of bigger companies, or what are called ‘large-cap’ stocks. For example, the largest holding in a passive fund tracking the S&P 500 today would be Apple, which accounts for 7% of the Index, and the smallest holding would be Xerox, representing 0.01% of the S&P 500. Passive investing is typically cheaper, and is certainly less complicated.
What is ‘active investing’?
In contrast, ‘active investing’ is a more hands-on approach that typically relies on more frequent buying and selling based on the insights of a portfolio manager (and, in the case of most funds, a staff of researchers). Active investors often seek to ‘beat the market’ by trading often to take advantage of short-term changes in stock prices. Active funds rely on a research staff to predict what stocks will do better over the short and medium term, and to decide the quantity of each stock to be held at any given moment. The goal is worthy, but active investing has historically underperformed passive investing over many time periods, largely because 1) research staffs are expensive and, 2) as Michael Mauboussin writes in The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, “Investing is dominated by luck, because investor skill level has risen to the point where the market is largely efficient.” In other words, no matter how hard they try, researchers and portfolio managers may not be able to deliver better results than the efficient capital market.
Some economists have speculated that an active approach to investing offers added value in a crisis. However, a paper from Professor Lubos Pastor from the University of Chicago analyzed how active and passive approaches performed in the market downturn caused by the COVID pandemic. The research found that this ‘value add’ was nonexistent, on average—and that 54% of active management did not beat their benchmark. In other words, to succeed at ‘beating the market,’ active managers must be very (very!) good at picking winning stocks.
So… what’s that third option?
Wise investors may want to consider a third option: ‘factor investing.’
Factor investing focuses on identifying the common attributes of companies whose stocks do better over time. These factors include things such as having low amounts of debt or maintaining consistent profitability. Other factors that may be considered include market cap, credit rating, stock price volatility, and growth vs. value. You can think of factor investing as a sort of middle ground between active investing and passive investing. Like active investing, it requires portfolio managers to pick stocks based on available information (in this case, the factors that are associated with performance). Like passive investing, it offers diversification and view toward longer-term growth. Importantly, Professor Pastor’s research found that 60-80% of active funds did not beat various combinations of factors. In other words, factor investing outperformed active investing—by a long shot.
The great news is that factor investing has become much more accessible over the past 20 years. Many low-cost Exchange Traded Funds (ETFs) and mutual funds make it easy to take advantage of factor investing—including some that are on the Schwab menu for the KP Keogh and 401(k). Working with an advisor can expand your options to include almost any ETF traded on the American Stock Exchange. While factor investing has “historically provided higher returns than market-based strategies” (see 3 Factor Investing Myths), it is no silver bullet, and it isn’t right for every investor. I’m happy to help you identify the most appropriate investment approach based on your asset allocation and risk tolerance (and don’t be surprised if factor investing finds its way into the mix!).
