Active vs. Passive Investing: Which Approach Offers Better Returns?

In the past couple of decades, index-style investing has become the strategy of choice for millions of investors who are satisfied by duplicating market returns instead of trying to beat them. Research by Wharton faculty and others has shown that, in many cases, “active” investment managers are not able to pick enough winners to justify their high fees.

But does active investing become more appealing for high net worth investors, who have opportunities that small investors do not?

Wharton’s Investment Strategies and Portfolio Management program offers five days of intensive training for finance professionals and others concerned with that and similar questions.

Wharton faculty members with in-depth knowledge of portfolio management explore topics including:

  • Modern portfolio theory
  • Behavioral finance
  • Passive and active vehicles
  • Performance measurement
  • Use of alternative investments such as hedge funds, derivatives, and real estate

While actively managed assets can play an important role in a diverse portfolio, Wharton faculty involved in the program say that even large investors often do best using passive investments for the bulk of their holdings. Active investing, they say, can nonetheless be useful with certain portions of the portfolio, such as those invested in illiquid or little known securities, or holdings tailored to a specific purpose such as minimizing losses in a down market.

“Passive” Strengths

Even for wealthy investors, passive holdings have a strong appeal, says Christopher C. Geczy, Wharton adjunct professor of finance and academic director of the Wharton Wealth Management Initiative. “The big issue still applies,” he says. “That’s the issue of whether you believe in trying to beat the market or whether you believe in [minimizing] costs. Some of the most successful entrepreneurs I know think about costs.”

Passive, or index-style investments, buy and hold the stocks or bonds in a market index such as the Standard & Poor’s 500 or the Dow Jones Industrial Average. A vast array of indexed mutual funds and exchange-traded funds track the broad market as well as narrower sectors such as small-company stocks, foreign stocks and bonds, and stocks in specific industries.

Among the benefits of passive investing, say Geczy and others:

  • Very low fees -- since there is no need to analyze securities in the index
  • Good transparency -- because investors know at all times what stocks or bonds an indexed investment contains
  • Tax efficiency -- because the index fund’s buy-and-hold style does not trigger large annual capital gains tax.

Actively managed investments charge larger fees to pay for the extensive research and analysis required to beat index returns. But although many managers succeed in this goal each year, few are able to beat the markets consistently, Wharton faculty members say.

Over a recent 10-year period, active mutual fund managers’ returns trailed passive funds consistently, says Kent Smetters, professor of business economics at Wharton.

On an after-tax basis, managers of stock funds for large- and mid-sized companies produced lower returns than their index-style competitors 97% of the time, while managers of small-cap stocks trailed 77% of the time.

“In case you are curious, those very few investment managers that outperformed the passive index were still likely to underperform in the future,” Smetters says. “In fact, outperformers had only a 20% chance of repeating the following year, and … just a 10% chance of outperforming three years in a row.”

Most experts and experienced investors know the reason: It’s just too hard for an asset manager to pick a portfolio that outperforms the market by enough to make up for the 1, 2 or 3% fee that must be charged to support the stock and bond picking operation. Many index-style mutual funds and exchange-traded funds charge less than 0.2%, some less than 0.1%, giving them a huge cost advantage.

“Active” Advantages

Still, many financial advisers recommend actively managed investments for significant portions of their clients’ portfolios. Active management includes mutual funds and exchange-traded funds, as well as portfolios of stocks, bonds and other holdings managed by financial advisers. Among the benefits they see:

  • Flexibility  –  because active managers, unlike passive ones, are not required to hold specific stocks or bonds
  • Hedging  –  the ability to use short sales, put options, and other strategies to insure against losses
  • Risk management  –  the ability to get out of specific holdings or market sectors when risks get too large
  • Tax management – including strategies tailored to the individual investor, like selling money-losing investments to offset taxes on winners.

Wharton finance professor Jeremy Siegel is a strong believer in passive investing, but he recognizes that high-net-worth investors do have access to advisers with stronger track records. In that case, a management fee is not as burdensome.

“Obviously, the more money you have the more elite personal-finance advisers you have access to,” Siegel says. “You get more for your 1% because you are going to get better people.”

How does the investor find a top-quality adviser? That’s one of the issues explored in Investment Strategies and Portfolio Management, which also covers topics such as fund evaluation and selecting appropriate performance benchmarks.

As a rule of thumb, says Siegel, a manager must produce 10 years of market-beating performance to make a convincing case for skill over luck.

Selection Strategies

The choice between active and passive investing can also hinge on the type of investments one chooses.

Passive management generally works best for easily traded, well-known holdings like stocks in large U.S. corporations, says Smetters, because so much is known about those firms that active managers are unlikely to gain any special insight. “You should almost never pay for active management for those things.”

But in certain niche markets, he adds, like emerging-market and small-company stocks, where assets are less liquid and fewer people are watching, it is possible for an active manager to spot diamonds in the rough.

It’s a complex subject, especially for high net worth investors with access to hedge funds, private equity funds, and other alternative investments, most of which are actively managed. Participants in the Investment Strategies and Portfolio Management program get a deep exposure to active and passive strategies, and how to combine them for the best results.