Active vs. passive investing: Which management strategy works best?
What are active and passive management? (4:27)
In a way, passive management is like “autopilot” — the fund manager feeds parameters into a computer, and the fund manages itself. Active management costs more, but in return there's an actual pilot at the helm of the craft, attempting to find the best route. (This metaphor is a simplification, but conveys the basic idea.)
So which are best, passively-managed funds or actively-managed funds? One oft-cited statistic (for which I still have not found a source) is that funds with actively managed portfolios fail to beat the market 80% of the time. That's why so many people preach the value of passively-managed index funds: you're not going to beat the market, but you're not going to underperform, either.
In his book Saving and Investing, Michael elaborates on the difference between actively managed fund and passively managed funds. In particular, active portfolio managers practice the following strategies in an attempt to beat the market:
- Market timing — They try to buy low and sell high in order to maximize returns.
- Security selection — Active managers over-weight certain stocks and bonds based on what they believe will happen. Other securities are under-weighted. For example, if I believe that Microsoft is likely to show increased earnings, I might make the portfolio I'm managing extra heavy with Microsoft.
- Sector selection — Rather than give added weight to individual stocks, a fund manager might give extra weight to an entire sector. A manager who over-weighted his fun in tech stocks in 1999 looked like a genius, but he looked like a fool if he was still in them two years later.
The trouble is that while active managers might be better than you or me at timing the market, or at picking a hot stock, they're still no better than the market as a whole. That's why so few actively managed funds are able to compete with index funds.
See also this recent USA Today article: Great minds don't think alike about index funds. Tomorrow we end our week with a crash-course in hedge funds, a subject about which I know nothing. (I don't even know what a hedge fund is!)