Investing: Active vs. Passive Management

Investment managers manage the investments of pooled funds—such as mutual funds and similar vehicles like exchange-traded funds—or investment funds owned by institutions, such as pension funds or endowment funds, or separately-managed accounts for individuals, or hedge funds—which are like mutual funds but are subject to less-strict rules.

“It depends on the cost” is the best answer. Is it worth spending more than a minimal amount to try to beat the market?

Managers of equity investment assets are divided into two main categories. Those who try to beat stock market averages are called active managers. Their practice is called active management. Investment advisors who work for large banks and brokerages typically recommend higher-cost, active managers.

Those who do not try to pick stocks to beat the market averages are called passive managers. Their practice is called passive management.

Passive management

Passive management strategies don’t try to determine which stocks are better than other stocks. Instead, they usually invest in nearly all the stocks in the stock market, or all the stocks in some subcategory—for example, the Standard and Poor’s 500 index. This investment methodology is called “indexing”. The idea is to hold a portfolio that is allocated exactly the way the whole market or submarket is allocated. Thus, investment performance will neither beat, nor will fall short of (except for a small fee), the market index.

It is not really necessary for a passive strategy to adhere strictly to a market index—though, in theory, that can afford the best possible diversification. All that is necessary for a strategy to be passive is that it not attempt to pick stocks, or to time when to get into or out of the market or any market segment.

Fees for passive investment management are very low—as low as 20 basis points (20 hundredths of a percent, or a fifth of a percent) or less for individual investors making small investments in major market index funds, and as low as five basis points (five hundredths of a percent, or a twentieth of a percent) or less for large investors and institutional investors. For investments of $100,000 or more the lowest fees for broad U.S. domestic index funds are now ten basis points or less. Institutional investors get still lower basis point fees because their passively managed portfolios can be gigantic, in the hundreds of millions or billions of dollars. This size results in a cost reduction due to economies of scale.

In addition to index portfolios allocated the same as the market or a submarket, there have arisen—as a marketing reaction to the popularity of index funds—a variety of so-named index funds, quasi-index funds, and fake index funds that lose many, most, or all of the benefits of true index funds. These can usually be spotted by their higher fees.

Active management

In contrast to passive investment management, active management tries to distinguish stocks that will perform better—that is, will have higher future rates of return—than other stocks in the market. Fees for active investment managers are much higher than for passive management because people who pick stocks are paid extremely high salaries, because they often buy outside investment research, and because they have higher profit margins.

Fees for actively managed mutual funds—the domain of the individual investor—range from a low of about three-tenths of a percent to a high of well over three percent per year, with averages in the one to one-and-a-half percent range. Individual investors can also invest with separate account managers who charge only about half a percent for a minimum investment of $100 thousand. But they can invest with these managers only through an advisor—which means they’ll also have to pay the advisor.

For institutional investment funds the cost for active management is lower than for individual investors because the funds are usually larger than individuals’ assets. But the cost for active management is still much higher than for passive management.

How active managers pick stocks

For active managers, most of the effort goes into picking individual stocks. Sometimes they try to evaluate the stock market as a whole—when to get into it and out of it—and how much to allocate to individual market sectors, like energy or technology.

The routine for picking stocks at a typical active investment management firm goes something like this. The database of all stocks (such as all U.S. domestic companies) is screened to reduce it to an eligible set of about 200 stocks. The screening is done with the help of database filters on characteristics like earnings growth, trading volume, price/earnings ratio, and debt/equity ratio. Companies with too high a P/E ratio or too high a debt/equity ratio, or too low earnings growth or trading volume might be screened out—or an entirely different screen might be applied, depending on the manager’s investment philosophy. In addition, research from independent research reports, industry contacts, and general reading comes into play.

Fundamental analysis of the companies in the remaining list—exhaustive analysis of their financial statements and filings—is then performed to generate earnings forecasts. The forecast is usually of the earnings in the next year and the earnings growth rate thereafter. The “present value” formula—a mathematical formula that discounts back to the present day the value of future earnings—is then used to deduce the “true” price—the price at which the stock of the company “ought” to be trading. This “true” price is compared with the actual price in the market. If the true price is higher, then the stock is a bargain at current market prices and should be bought. If the true price is lower, then the stock is currently overpriced and should be sold, or not bought.

Such is the procedure at active money management firms—along with similarly determining whether the market as a whole or sectors of the market are overvalued or undervalued. For this activity an extra one percent or so of assets (less for larger clients) is typically charged by the manager.

Then, on top of the fee charged by the manager, an investment advisor—if the investor has one—attempts to select among the stock-picking money managers to determine which are best at stock-picking. For this additional service the advisor charges up to another one percent.

 

 

What is the unrecoverable cost of active management?

Numerous studies have found that there is no correlation between fees for active management and investment performance—in other words, excess fees are not compensated by excess performance, and therefore are a dead weight. How much is lost to excess fees? The following graph shows what wealth accumulation would have been over the historical 40-year time period 1967-2006 (approximately an investing lifetime):

(Click on graph to expand.) 

 The graph shows that compared to the lowest-cost alternative (broad-market index fund or exchange-traded fund) an investor will lose 40% of lifetime wealth accumulation to fees by investing in the average mutual fund; 59% of lifetime wealth accumulation by investing through the average investment advisor; 72% of lifetime wealth accumulation by investing in the average hedge fund; and 93% of lifetime wealth accumulation by investing in the average fund-of-hedge-funds. Since the evidence shows that there is no way to distinguish in advance which managers or investment vehicles will perform above average and which below average, these numbers represent the losses to active management fees that investors can expect over their investing lifetimes.

 

 

Losses to taxes

Active investment management has the added disadvantage that it causes a taxable investor to pay more taxes as compared to passive management. This is because capital gains are realized far more frequently through active management than through passive management. Passive management generally buys and holds stocks for a very long time, trading them only very infrequently.