2.8: The Great Debate ‒ Active Management versus Passive Management

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The past several years has seen great controversy over the value of active management in the mutual fund industry. Are the mutual fund investment managers who research, identify, choose, and monitor the investments in their mutual funds actually worth the high salaries they are paid? Should investors instead solely concentrate on low-cost, passively managed index mutual funds? We now explore the debate.

The History of Passive Management

The history of passive investment management, also known as index investing, goes back to the late 1960’s. Before that time, all mutual funds were actively managed. The mutual fund managers researched, identified, chose, and monitored the investments in the mutual fund portfolio. Some individuals in the industry and some in the world of academia began to question the value of the average mutual fund manager. They conducted studies that compared the average mutual fund manager with a randomly selected portfolio. They “had a monkey throw darts at a dartboard” and chose those stocks. They then compared this random portfolio to the portfolios of mutual funds. The monkeys won! The average mutual fund portfolio manager did not beat the random portfolio.

Index Funds

In the early 1970’s, some companies decided to put this research into practice. They experimented with setting aside a percentage of their portfolio for non-active management. They created funds that were purely passively managed which were not available to the general public. Instead of a random group of stocks, though, they choose a popular stock index. A stock index is simply a list of stocks. We will cover stock indexes in detail in our next chapter. One of the most popular indexes is the Standard & Poor's 500, also known as the S&P 500. In 1975, John Bogle of The Vanguard Group started the first retail index mutual fund available to the public, the Vanguard Index 500. The success of this mutual fund and their other index funds has made The Vanguard Group the largest mutual fund company in the world. Many mutual fund companies now offer index funds.

As discussed in the section on fees, index funds generally have very low operating expenses. There is a simple reason for this: They do no research. You or I could manage an index fund. All you need to do is look at the list of stocks or bonds in the index. You then purchase the items on that list and you avoid any choices that are not on the list. When an item is added to the list, you buy it. When an item is removed from the list, you sell it.

As we warned back in the section on fees, the would-be index fund investor must be vigilant. There are many index funds that have high fees. Many are furtively slipped into employer-sponsored retirement plans such as 401k’s, especially by insurance companies. Be on your guard! You are the last line of defense for your fellow colleagues.

Exchange-Traded Funds (ETFs)

The success of index funds led to the emergence of Exchange-Traded Funds (ETFs). The first ETFs were passively managed and like their index fund cousins, had very low operating expenses. To review, ETFs are bought and sold on the open market so you need a brokerage account to invest in them and you incur brokerage commissions. However, some enterprising mutual fund companies started their own brokerage firms and allow investors to buy and sell ETFs without commissions. Also, several brokerage firms now offer no-commission trades to their clients. (We will discuss how the clients are being charged in our next chapter. No-commission transactions does not mean free transactions.)

The subsequent success of ETFs has led the industry to create ETFs that are actively managed. Since these newer ETFs are actively managed, they will have higher annual operating expenses since doing the research necessary to actively manage a portfolio is costly. The industry is nothing if not complex. You are going to have to explain to your family, friends, and colleagues that not all ETFs are index funds.

The Financial Media Orthodoxy versus Not So Common-Sense Heresy

The financial media has made up its collective mind. The incessant drumbeat is that actively managed funds can’t beat passively managed funds. The drumbeat goes something like this: “You are better off investing in a passively managed portfolio of index funds or ETFs. And, oh, by the way, buy my book or, better yet, sign up for my monthly newsletter that keeps you abreast of the best index funds and ETFs. It’s only $50 per month. A bargain!” Do the talking heads in the financial media have a point, though? Are passively managed index funds and ETFs better than actively managed funds?

It is true. The average actively managed mutual fund does not beat its respective index. There are a variety of reasons why this may be so. One of the most important reasons is that the average mutual fund has an expense ratio of 1% whereas an index has no expense ratio; it is just a list of stocks or bonds. Therefore, the mutual fund must beat the index by 1% just to match the return of the index! Another important factor has been the culture and competitiveness of the investment industry. New mutual funds starting out in their careers knew very well that they must produce quickly or they wouldn’t be around for long, typically 1½ to 2½ years. This led many to take on more risk than would normally be appropriate. The managers knew that if their choices did well, they would get to keep their jobs and be showered with love and attention and a whole lot of money. Of course, if their choices didn’t produce good results, oh, well, they weren’t going to be around for very long, anyway. Luckily, much of the mutual fund industry has seen the error of their ways and adjusted accordingly. New mutual fund managers now normally get more time to prove their worth. Dear Students, no investment strategy is perfect.

The same can be said to be true for passive management, though. No investment strategy is perfect. What are the disadvantages of passive management? Many decades ago, Benjamin Graham, the author of The Intelligent Investor, warned against any investment strategy that removed human judgment from the investment process. Passive management does just that. Passive management removes the ability of a mutual fund manager to make a judgment regarding the value of an investment. Passive fund proponents might argue that this is precisely the point. That is the beauty of an index fund. If there is no judgment, there can be no emotion attached to the choices made.

However, active fund proponents would counter by pointing out that there are instances when a company’s stock, for example, has risen to the point where it is absurdly valued. In this situation, the passive fund manager is not able to sell. Instead, the rise in the price of the stock raises the value of the stock in the index. Hence, the passive fund manager must buy more of the stock. This raises the price even further in what essentially becomes a feedback mechanism. The higher the price of the stock, the more the index fund managers must buy the stock. The more stock the index fund managers buy, the more the price of the stock rises. The opposite is true when the price of a stock has been beaten down. The index fund manager must sell the company as it is now worth less within the index. Whereas the active manager has the ability to take advantage of an attractive price for a stock that they might want to have in their portfolio. In the presentation, we discuss this phenomenon and two popular indexes and what happened when the indexes were skewed by market euphoria. We will return to them later on in the semester after we have discussed the particular indexes and the statistics that accompany them.

Ultimately, though, the fundamental flaw in the argument of the passive management proponents is their use of the word average. As Don Phillips, the founder of Morningstar, said, “The real-world average of almost anything is an ugly thing.” Yes, the average fund does not beat their respective index but there are many mutual funds that are above average. There are many mutual funds that have beaten their respective indexes and have done so over many decades. Here is a quote from a retired mutual fund manager with over 35 years of experience at the time:

“As with any human endeavor, whether it is athletic competition, the performing arts or technological innovation, some people clearly perform at a higher-than-average level.” – Mark Denning, mutual fund manager with over 35 years of investment experience

Many actively managed funds do beat their respective indexes over time. Prudent, long-term oriented investors seek mutual funds that have consistently beaten their respective indexes over decades, in good times and bad. We will return to this discussion later on in our journey together. For now, we will end this discussion of the controversy over active versus passive management with another quote from Don Phillips:

“The active-versus-passive debate has been greatly overplayed to the detriment of many fine, actively managed fund shops and to intelligent investment discourse.” ‒ Don Phillips, Founder and Managing Director of Morningstar

Let us relate one last note about the active versus passive debate. Many passive fund advocates can become quite agitated and angry if you attempt to discuss both sides of the debate. Mr. Phillips hints at this in his mention of “intelligent investment discourse.” When you mention some of the mutual fund families that have done well over decades, you may even be accused of being an industry shill and peddling for the companies. Once again, we ask, “Who said investing was dry and uninteresting?”