Active vs Passive Investment Management
Actively managed funds consistently under-perform their benchmarks. Wealth is sacrificed by those who invest in actively managed funds. The data and the theory are both undeniable.
You can get passive vs. active data and research here. Look at the long-term results of active management versus the market. Focus on the longest data available. The US reports the percentage of funds beaten by the market return and Canada reports the percentage of funds beating the market return. Both give a failing grade to active management.
Passive management: the attempt to replicate the return of the market by owning every security in the market at its market capitalization weight. This is also referred to as market capitalization index investing.
Active management: the attempt to outperform the return of the market through superior research, analysis and tactics.
Note that passive is a word with negative connotations. This is not so in the context of investing. Here is a good summary article. I would critique that the author does not grasp nor mention the zero-sum game nature of investment out-performance.
Active Management vs. Passive Management
Active management employs research, resources and tactics to outperform the investment return of the market. Passive management employs resources and tactics to mimic the return of the market. Active investment management is expensive. It requires high-salaried MBA’s, CFA’s, and research analysts to discover investments they believe will outperform the market. Just like any business, these costs are passed on to the client. High-priced employees and resources to support them are not required when the goal is to mimic the returns of the market. Passive management has significantly lower expenses and therefore lower cost compared to active management.
Fundamental misunderstanding of how the market works
All active managers explain how they will outperform the market. It is arithmetically certain that all won’t. This is as certain a fact as many students will under-perform the class average. It is nonsensical to claim all students can outperform the class average. It is equally nonsensical that all active managers can outperform the market return.
Two fundamental tenets of how the market works:
Equity markets rise over the long-term. There are fundamental reasons why this is and will remain true. We get smarter and better at what we do over time and generations and companies continually reinvest the non-dividend portion of profit into the business. Only bad public policy can stop the rise. Venezuela is the current example of bad policy wrecking an economy. Markets rise in the long-term. Notice the upward sloping lines.
Because equity markets rise over time, investing in markets is a positive-sum game. All can have more than their original investment. However, it is arithmetically certain that performance around the market return is a zero-sum game. Any out-performance is exactly offset by under-performance. This is pre-cost. Cost shifts the post-cost return spectrum toward under-performance.
Ramifications of Point 2
Performance around the market return is a zero-sum game. This is either misunderstood or ignored. If the market returns 7%, the average rate of return of all participants must equal 7% pre-cost. The group of all participants can not average 8% or 6% or anything different than 7% pre-cost in this example. If one or more participants earn more than the pre-cost market return, it is certain that one or more must earn less than the pre-cost market return. This is as certain as if one student earns a mark higher than the class average, at least one student must earn a mark lower than the class average.
This is the same for a negative return. If the market returns -7% participants as a group must average -7% pre-cost. The group of all market participants can not average anything different. If one or more earn more than the market average, -5% for instance, it is certain that one or more earn less than -7%.
This is pre-cost. Cost makes it worse. Slice off total cost from pre-market return to obtain after-cost, actual, relevant return.
The Group of Passive Investors Always Outperform The Group of Active Investors in Any Time Period Measured.
Every market participant, whether an individual managing his own portfolio or market professional managing client money, is either a passive or an active participant. From the group of all participants, each is separated into one of two groups. A passive participant is one who is passively invested 100% of time of the period being measured. An active participant is one who does not meet the definition of a passive participant. Each participant is therefore either one or the other. Just as the group of all participants must average the market return, the combination of the passive participant group and the active participant group must average the market return.
Each passive participant earns the market return pre-cost by definition. The passive participant group therefore averages the market return pre-cost. Knowing the market return, and knowing that one of two groups earns the market return pre-cost, we know two of the three variables and can solve for the third. Simple arithmetic dictates that the other group, the group of active participants, must average the market return. The class average analogy helps understanding.
Note, unlike passive participants, I am not saying that every active participant will receive the market return pre-cost. Many will outperform, and many will under-perform. However, within the active participant group, dollar out-performance is exactly offset by dollar under-performance, The pre-cost average to the group of active investors must equal the market return. This is an arithmetic certainty.
It is a fact that the cost to passive investing is lower than the cost to active investing, significantly lower in most cases. From this follows that the average after-cost return to the group of passive investors is always higher than the average after-cost return to the group of active investors. This is an arithmetic certainty. Here is a graphic representation. Pre-cost, dollar outperformance is exactly offset by dollar underperformance around the market return. Cost shifts the post-cost return to the left by the amount of the cost. The greater the (your) cost factor, the greater the (your) shift to the left.
Some active participants will outperform the market pre-cost and after-cost. Some will outperform pre-cost and underperform after-cost. An offsetting, exact percentage of dollars invested at the beginning of the period measured will match pre-cost outperformance on the other side of the market return, or, underperformance, and cost makes performance worse. Again, this is certain. Any deviation from this is due to faulty measurement.
Faulty measurement is abundant. For example, most fund products advertised as Canadian equity funds typically hold a small percentage of non-Canadian investments in the portfolio. This is reasonable. But, if so, their benchmark should not be solely the Canadian market but a blend of the Canadian market and non-Canadian markets. Another example: consistently underperforming actively managed funds are shut down by the firm and their negative performance disappears. Note that asset management firms want to attract assets. It is tough to advertise a fund that has consistently underperformed.
There is abundant research on the superiority of passive management versus active management that can be found on the internet. This is likely the best piece and is from Nobel prize winning economist William Sharpe. It is only three pages and you can ignore some of page 2 and all of page 3.
A poker analogy helps understand. Would you rather be the gambler or the non-gambler in the magical poker game? Simple arithmetic is on the side of the non-gambler. If you invest with a financial advisor or financial planner, you are almost certainly one of the gamblers. If you want to be a non-gambler, you almost certainly need to Be Your Own Financial Advisor.
Is Active Investment Management Always Bad?
I would not conclude this if the statement is that broad. There are many pension funds that are actively managed. However, their cost is extremely low. There are many individuals managing their own portfolio actively. They pay no MER. Many have developed expertise and do this well. It is the high cost that is bad for one's financial health. I would conclude that active management through a financial advisor / planner necessitates high cost. This is very much bad for you. There are passively managed investment products with high MERs. These are bad as well. Here is the Ontario Securities Commission's primer on costs and fees. The MER is key.
Summing It Up
Measured properly and after-cost, the investment returns to the group of passive participants always outperform the group of active participants in each and every time period measured. Retail investors in Canada using the services of a financial advisor / planner pay high actively managed charges. The difference between what they pay and what they could pay by BYOFA is enormous.