The Active versus Passive Debate

Many investors want to know whether it's better to purchase an actively managed mutual fund or take the passive route and buy an index fund. Will the extra fees you pay for the expertise of a portfolio manager lead to higher returns, or should you just try to match the market? This question has no definitive answer, but thinking about a few key considerations may help you reach your own conclusions.

For the long-term equity investor, the debate between active and passive strategies rests on three main considerations: 

1. Market efficiency
2. Portfolio construction
3. Historical performance

Let's look at each in more detail.

1. Market Efficiency

At the centre of the active versus passive debate is the question of whether stock markets are efficient.

What is an Efficient Market?

In an efficient market, stock prices accurately reflect all the facts about their underlying businesses. In this environment, trying to "beat the market" is pointless. That's because most active management strategies seek to buy stocks that are mispriced in some way. In an efficient market, mispricing is an illusion; all stock prices correctly reflect their risk and return characteristics. By this reasoning, if you want exposure to the growth potential of equities, it may be better to consider purchasing a low-cost basket of stocks through an index fund.

But are Stock Markets Really Efficient?

As it turns out, the theory of efficient markets has a lot of holes. The toughest challenges come from behavioural finance researchers who have shown that stock prices are often influenced by factors that have nothing to do with company fundamentals. When emotional elements like greed and fear take over, stock prices can take a holiday from reality. The euphoria that fuelled the technology stock bubble in 1999 and 2000 is clear evidence of this phenomenon.

This opens the door for active managers to exploit mispriced investment opportunities. 

2. Portfolio Construction

Obviously, there are important differences in how passive and active portfolios are managed. Let's look at a few of the index strategies first.

Index Construction Strategies

An index is meant to capture market movements by measuring price changes in a broad group of stocks.  But is the index an accurate benchmark for the market it seeks to represent? 

Some indexes involve a component of active management, because the people who decide what companies to include in the index have discretion in choosing stocks. For example, the components of the Dow Jones Industrial Average (DJIA) are selected by the editors of the Wall Street Journal. The DJIA has no predetermined criteria except that companies should be established U.S. industry leaders. From one angle, therefore, the DJIA looks like a low-turnover actively managed fund where the managers do double duty as journalists. 

The S&P 500 Index is also subject to human judgment. A team of Standard & Poor's economists and index analysts select stocks for the index. This committee follows published guidelines, but the rules are not strictly mechanical; there is still room for discretion in changing index components to represent the U.S. stock market. 

There are differences in how an index is divided among its component stocks. The most widely followed indexes, like the S&P 500, are market-capitalization weighted. A company with a market value of $50 billion gets two times the weighting of a $25 billion company. Market-cap weighting can create problems. 

Specifically, when a stock, industry or country becomes grossly overvalued it represents a larger part of a market-cap weighted index. For example, at its peak valuation, Nortel Networks accounted for about 30% of most Canadian stock market indexes. If you bought the index at that time you eliminated the risk of underperforming the market, but you took on a lot of stock-specific risk. To manage this problem, some indexes are “capped”. For example, the S&P/TSX Capped Composite Index imposes a maximum weight of 10% for a single constituent. 

Less common are price-weighted indexes (such as the DJIA), which give higher weights to companies with higher share prices. A company with a share price of $100 gets twice as much exposure in a price-weighted index as one with a $50 share price. A funny thing happens to price-weighted indexes when a stock is split. A $100 stock that's split two-for-one becomes a $50 stock. Consequently, the company's weighting in the index is cut in half, even though its market value is unchanged (on a market-cap weighted index, the same company’s weighting would not be affected). 

Active Portfolio Construction Strategies

Compared to indexes created to capture broad market price moves, active managers take a more selective and forward-looking approach. Essentially, active managers build stock portfolios that they believe have a reasonable chance of generating attractive returns. In fact, many managers pay little attention to the sector and stock weights of their respective benchmark indexes. 

The specific criteria of portfolio construction – such as growth or value investing, or a focus on small-cap or large-cap companies – vary widely across active managers. But whatever the strategy, buys and sells are based on the manager's judgment. In the end, when you hire an active manager, you're paying for that person's skill at evaluating opportunities expected to produce a profit. 

An active manager's success is judged by performance. This brings us to our final consideration. 

3. Historical Performance

Passive strategies, by their very nature, aim to replicate the performance of an index, and therefore investors can expect returns similar to those of the relevant market. They won’t underperform the market, but they cannot hope to outperform it, as active managers can. 

On the other hand, a sound investment strategy executed by an experienced professional investor can produce very good results for long-term equity investors. Granted, not every active manager will produce such good results — many active strategies used by mutual fund managers fail to beat their indexes over time. Successful portfolio management requires patience, intelligence, discipline and emotional strength. Not everyone has what it takes, but as in any field, a few people really excel. 

A skilled active manager can provide you with the good judgment of someone who has spent years — often decades — making capital allocation decisions. Past performance will not necessarily be repeated, but the track record of an individual manager or investment firm is important. 

In Summary

Again, there is no definitive answer in the active versus passive debate. As a self-directed investor, it is up to you to choose the investment philosophy that fits your beliefs and your situation. Indeed, you may wish to mix actively and passively managed investments in your portfolio. Whether you are an active or passive investor, there are a variety of products that can help you to achieve your investing goals. 

Use the resources in the Research Centre for help with your investment choices.