Investment snapshot: Active versus passive investing, part 1

investment snapshot
John P. Maguire of Rationalis Capital Management in Hinsdale | Submitted

We’ve started a new investment feature designed to give you some background on current market trends. Our fourth piece tackles the growing debate over investment strategy:

2013 was a terrific year for stocks as U.S. equity markets posted double-digit returns and the Standard & Poor’s 500 soared 32.4 percent, the largest increase since 1997.

But peer beneath the surface and it was not such a rosy year for large cap managers: 55.8 percent of them underperformed the S&P 500 Index that is the benchmark of their value. Boiling that down, for every nine large cap money managers—professionals who charge extra fees to outperform the market—five failed to measure up to the market.

Investors would have done better to plant their money in index funds. And 2013 was hardly an exception; if anything, the picture is even less flattering for large cap managers over longer periods of time. For the three-year period ending Dec. 31, 2013, four out of five large cap money managers underperformed their benchmark; if you expand the window two more years, the proportion who underperformed for that half-decade is still 73 percent .

In simple terms, active investment management is the art of individual stock picking and market timing. Passive management (often through index funds) refers to the buy-and-hold approach to investing. The debate over which is best for individual investors has been raging for over 40 years across all asset classes: large cap stocks, small cap stocks, value or growth, foreign or emerging markets.

The debate began in earnest in 1973 when Burton Malkiel wrote “A Random Walk Down Wall Street.” He presented academic findings that revealed most mutual funds were not beating the market indices. Until then most investors felt that investment managers could outperform market indices by actively buying and selling based on fundamental research and/or quantitative methods.

Then, on Dec. 31, 1975, John Bogle, the founder of the Vanguard Group, started the first index fund for individual investors. At the time, his peers derided the fund, which Bogle simply named the “First Index Investment Trust,” as “Bogle’s folly.” Detractors insisted that investors are never going to be satisfied with average returns.

Yet, by the end of 2011, index funds in the U.S. had grown to nearly $1.1 trillion, or 24 percent of the total mutual fund market.

On top of that, academic studies have overwhelmingly supported Malkiel’s point: passive investment management outperforms active management, especially in the large cap arena.

Why then do investors still choose active money managers?

The easiest answer, according to 25 years of research in behavioral finance, is that individuals are less than perfectly objective and rational. They understand that most investment managers underperform but they rationalize that they will find the exception. Why do people gamble? Because they think they can win.

When choosing between active or passive investment strategies, is there an easy answer for investors? We will address that question in the next column. 

DISCLAIMER: The information contained in this article is not a solicitation to sell securities or investment advisory services where such an offer would not be legal. Information included in this statement regarding market or other financial information is obtained from sources believed to be reliable. Past performance is never a guarantee of future performance.

John Maguire has been an Investment Advisor for more than 30 years. He is a Managing Partner of Hinsdale-based Rationalis Capital Management, LLC, online at www.rationaliscapital.com. He can be reached at john@rationaliscapital.com.

This content was submitted by a member of the community. We’d like to hear from you, too! To share stories, photos, video or events for our calendar, please email Community News Manager Michael Cronin at michael@aggrego.com or use the online submission tool.
Tags:

0 Comments

Modal