Six Reasons Why Passive Beats Active Investing

The spectacular demise of Britain’s most famous active fund manager, Neil Woodford, has reopened the debate as to whether you’re better off using active funds or passive funds.

Of course, it’s a question that can only be answered with the benefit of hindsight. Only when you come to retire will you be able to say whether or not you made the right decision. All you have to go on now are probabilities — and what the evidence says about the likely outcomes.

What that evidence tells us, in a nutshell, is that although you may receive higher returns by using active managers, the overwhelming likelihood is that you won’t.

1. Passive investing puts the odds on your side

There’ve been many academic studies on active fund performance, and the the findings are broadly consistent. Over the long term, only a tiny proportion of actively managed funds outperform the market on a cost- and risk-adjusted basis. Dr David Blake from Cass Business School, who led one of the most in-depth studies on the subject, puts the figure at around 1%. What’s more, he says, those very few winners are all but impossible to identify in advance.

With index funds or passively managed ETFs, on the other hand, you are guaranteed near enough the market return. Yes, there’s something called tracking error which means that the returns you receives will deviate slightly from the returns of the index. Then, of course, there’s the annual charge. But even when this is added to tracking error, the difference between your returns and the index shouldn’t be more than around 0.20%. That sort of return will put you ahead of the vast majority of active investors.

2. Passive investing saves money

You can’t predict the news, or future market movements, but one thing you can control as an investor is how much you pay. It’s hard to over-estimate the importance of cost.

Studies have consistently shown that cost is one of the most reliable predictors of long-term performance. The more you pay, the lower your returns are likely to be, and the greater the chance that your chosen fund won’t survive.

Index funds are vastly cheaper than active funds. You can now track an index for fewer than ten points, i.e. less than 0.10%.

By comparison, investors using active funds typically pay 20 times as much or even more, once transaction costs and other fees and charges (many of them hidden) are factored in.

Because of the effects of compounding, the difference in cost over many years can be colossal.

3. It’s quicker than active investing

Life’s too short to keep monitoring your portfolio to see how your funds are performing. Who wants to spend precious time reading what the various platforms and media pundits are saying about particular funds? The beauty of indexing is its simplicity.

You’re not trying to beat the market; you’re simply taking your share of the profits of businesses by capturing market returns.

As long as you’re comfortable with the level of risk of taking, and you rebalance your portfolio once a year or so to restore the original asset allocation, there’s nothing else for you to do.

4. Passive investing is more transparent than active investing

Buy a fund that tracks large-cap UK equities and you know it will contain the stocks of large UK companies, and nothing more; the same applies to a European small-cap fund, a US Treasuries fund and so on.

But buy an active fund and you could be investing all sorts of things. It’s very common, for example, for an equity fund to contain bonds and cash. An active manager will often take more risk by tilting towards smaller or less liquid stocks.

And remember, your fund’s investment style can drift over time. Unbeknown to you, your active fund portfolio could in fact be rather riskier than it was when you started investing, as investors in the Woodford Equity Income Fund have learned to their cost.

5. Passive investing spreads your risk

The benefits of diversification have been proven beyond doubt. Not only does it reduce your exposure to certain types of risk, it can also generate higher returns, especially over long periods of time.

Of course, the most important thing is to spread your risk across different asset classes, but it also pays to be diversified within each asset class.

An active UK equity fund might contain, perhaps, 25 stocks. But a FTSE All Share index fund, for example, will comprise around 1,000 stocks, in other words 40 times more.

If one of the 25 stocks in the active fund portfolio suddenly falls sharply in price, that would have a significant impact on the fund’s value. But if that stock were just one in a thousand, the damage would be very much smaller.

6. Passive investing reduces the human error found in active investing

Studies have repeatedly shown that one of the biggest factors in underperformance is a lack of investor discipline. People give in to their behavioural biases and make decisions that harm their portfolios, such as buying and selling at the wrong time or simply overtrading.

Because an active fund is trying to beat the market, the fund manager is prone to make those same mistakes.

By contrast, the manager of an index fund is aiming to match the market return as closely as possible. Also, because the passive investor has decided that the market return is sufficient, he or she is usually happier to stay invested through thick and thin.

No, it doesn’t always work that way —passive investors can act irrationally too — but the nature of passive investing makes them more likely to stay the course and maximise their returns over the long term.

Conclusion: passive investing versus active investing

You rarely see the virtues of passive investing extolled in the financial media. Why not? Well, that’s another story.

But there are six compelling reasons to use passive funds.

Remember to focus on probabilities. You’ll almost certainly be glad you did.

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