Active vs Passive Investment

You may remember we talked a little about trade-offs already. Well another investment trade off is active vs passive strategy. This is a trade-off we are hearing more and more about these days. Fifteen years ago, almost nobody was talking about index funds and Exchange Traded Funds (ETFs). You would either buy stocks and bonds directly; or you would buy a mutual fund, run by a manager who was benchmarked against “the market”. Hedge funds were only just becoming accessible to regular investors, rather than being for sophisticated or high net worth investors only.

You may have heard about a bet that Warren Buffet made almost 10 years ago: He bet that a passive investment in the S&P 500 index would beat any given portfolio of hedge fund strategies over a 10 year period ending December 31st 2017. The only takers were an alternative investment specialist firm called Protege Partners LLC, and there is a million dollars riding on it to go to the winner’s charity of choice.

So how’s it going? Well, in truth it’s not even close. Despite starting the bet before the 2008 financial crisis the S&P 500 is sitting on a return of 85.4%. (7.41% p.a.) The hedge funds average is 22%. (2.2% p.a.)

So what can we learn from this? Well here are a few lessons:

• It’s time in the market that matters, not timing the market.
• Fees really matter – the hedge funds have performed ok, and with lower volatility. But an annual fixed fee and 20% performance fees are going to eat into investor returns.
• You have to hang in there! Think back to 2008 – the housing crisis, Lehman Brothers goes down, the stock market plunges, it feels like the end of the world…and you just invested a chunk of your savings in the S&P 500! Be honest here, would you have sat on that bet and waited? It’s easy to say yes with hindsight, but an awful lot of people sold investments at the bottom of the market, when despair was at its highest, and then sat out in fear and missed the big rebound.

So does this bet settle the active vs passive investment debate? Well, not exactly. Hedge funds vs the S&P 500 is not really a good comparison. If, however,  it was US large-cap mutual fund managers vs the index, then we would be comparing apples with apples. According to this article, 66% of large-cap managers failed to beat the index in 2016, and if you lengthen the time period, the numbers just get worse. And out of the managers who do beat the index over a three year period, only about 5% go on to beat the index over the next three years. So we can conclude that it’s very hard to beat the market.

So does this mean we should just lump all of our money into an equity index fund?Although there are worse things you could do, it’s not a very balanced approach. Getting a diversified blend of different asset types, and rebalancing this blend over time, can help smooth out returns, lower risk, and make it easier to sleep at night when the stock market takes one of its downturns. We will look at this in more detail in future posts.