The Flinchum File
Thoughtful Economic Analysis and Existential Opinions

Long-Running Debate

11/22/2016

One of the longest running debates in the investment community is whether passive investing is “better” than active investing.  Passive investing involves trying to match a stock market index, such as the S&P 500 or the Nasdaq.  Examples would be exchange-traded funds (ETFs) such as SPY or QQQ.  Active investing tries to do better than the index.  Examples are most mutual funds.  ETFs are also cheaper than mutual funds.  Passive investing has “beaten” active investing for 22 of the last 26 years.  Is that proof of anything?

Active or passive should not be a binary decision, like voting.  Both types of investing have a place!

First, most studies of relative performance are based on the S&P 500 over some period of time.  That index is entirely large-cap stocks or big companies.  Those companies are better known to analysts, and their financials have been closely audited by many analysts for many years.  There is little new to be discovered.  However, studies of the relative performance of active and passive investing are much less convincing for small-cap stocks.  It is not imprudent to use ETFs for large-cap stocks and mutual funds for small-cap stocks.  And, I cannot say that ETFs or passive investing is ever appropriate for international stocks.

Another distinction is the stage of the business cycle.  The last 26 years have, on the whole, been in a bull market, where ETFs have the advantage, because they are 100% invested.  Mutual funds usually maintain a cash cushion, such as 5%, which is a drag in a bull market but a blessing in a bear market.  Mutual fund managers can increase their cash when the market is going down, exchange fund managers cannot.  I would rather have a mutual fund in a bear market than an exchange-traded fund.

A hard distinction to describe is value of expertise, which drives up expenses.  In passive investing, you are not buying any investment expertise.  In active investing, you are buying the advice of a portfolio manager.  Many investors find comfort in this.  I often find comfort in this extra expense but not in all cases.  The value of that expertise increases in a bear market, especially among small or mid-cap stocks.

Most of all, this debate is too broadly-brushed.  Even if passive investing is superior at all times for all assets, that does not mean that 100% of all ETFs beat 100% of all mutual funds.  For example, so far this year, 30% of all large-cap mutual funds have beaten ETFs, even though ETFs have the advantage with large caps.

Lastly, the “odd-lot” theory applies to this debate.  That theory suggests that small investors invariably do the “wrong” thing.  Today, we see small or retail investors getting out of mutual funds and piling into exchange-traded funds.  They bought the “sales-pitch” of passive investing.

Like life, investing ain’t that simple . . . even passively.

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