There’s been an enormous amount of research done by individuals in the finance community to try to prove that one strategy is better than the other (active vs passive investment styles), and the debate rages on, but a better way to look at the two investment styles is to realize that they each have their own strengths and weaknesses.
First, a brief description of the two, as there are many other sources you can look to for more detailed information:
Passive investment strategies — The investments in the portfolio tend to mirror an index (one of many examples would be the S&P 500 index). The portfolio is adjusted based on changes in the index.
Active investment strategies — The investments in the portfolio tend to not mirror an index, or tend to stray from the closest related index in an attempt to seek returns that are greater than the index. Adjustments in the portfolio occur based on the preferences of the portfolio manager.
Strengths and Weaknesses
The debate over which strategy is “better” has occurred because over certain periods of time one strategy may outperform the other; however, both should be considered valid, as the success of the strategy likely depends on the market environment and entry point.
The important idea to think about is that the point when a particular strategy (passive or active) is used may be more important than which strategy is used — they each perform well in different market environments: Passive strategies have typically outperformed active ones in highly-positive markets where investors are willing to take on risk, and active strategies have typically outperformed passive ones in more-reserved or negative markets — they both have their own purpose.
The most “successful” strategy in a given period depends on the popularity — i.e. the price-movement — of the investments that set the two strategies apart; those distinguishing characteristics are:
- Active strategies can hold cash and hedge (a volatility reduction technique), and…
- Active strategies typically pursue less-large and less-growth-oriented investments; more specifically they lean away from capitalization-weighting (i.e. they don’t invest more heavily in a company simply because it’s larger in size/capitalization), and they lean slightly toward value-oriented investments (see What Does the Price of a Security Really Mean? to distinguish price vs. value).
The popularity (i.e. the price-movement) of these distinguishing characteristics is what creates the active-passive cycle. There can be occasions where a small number of funds using one of these strategies outperform the majority of funds using the opposite strategy; and there can be occasions where the majority of funds using one of these strategies outperform the majority of funds using the opposite strategy.
However, more importantly the dangerous entry point for either of the two strategies is when the majority of investors begin to eschew one strategy for the other; they see results in one strategy and mistakenly decide that it’s the one that they prefer because “it has performed better”. Investors are then effectively moving their assets into the more popular investment strategy after its outperformance has already occurred.
The outperformance of passive investing over the past several years has been significant and the drastic flow toward passive investing should be concerning.
Chart from The Felder Report: Passive vs Active Fund Flows — from the post entitled There Has Never Been a Better Time To Be An Active (Thinking) Investor