Active vs Passive Investing & Evidence-Based Investing

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Source: SPIVA Scorecard 2020

What is Active vs Passive Investing

Active investing involves buying and selling specific stocks, or thematic ETFs.

Passive investing means buying and holding investments meant to match the return of an entire market (National or International).

Evidence-based investing is a rules-based system based on the best investing evidence available, aimed at reducing subjectivity in investing decisions.

The main differences in the two approaches to investing in the stock market are:

  1. The goal
  2. Time
  3. Expertise required
  4. Fees
  5. Results

The Goal of Passive and Active Investing

The goal of passive investing is simply to match the entire market, minus a very small fee. In contrast, active (or evidence-based) investors aim to beat this index.

Time Needed to Passive vs Actively Invest

Active investing is a time-consuming process. The investor or his/her hired help needs to extensively research each purchase and then monitor the company’s ongoing performance to ascertain if and when to sell. On selling, more research is required to find another good company to invest the cash in.

To become an active investor, you need to see digging through company data and reading balance sheets as a fun hobby and have plenty of time to invest in the process. Many who love the process choose a “core and satellite” approach. The majority of their investments are in broad-based index EFTs using a passive strategy. A small proportion of the portfolio is used to indulge in active investing.

Passive investing, on the other hand, can be a simple, lazy process. If you are a sloth-like investor like me you can even direct debit each pay to your chosen investment(s) with Pearler.

Expertise Needed for Passive vs Active Investing

Enough education to institute a reasonable passive investing plan can be gained from a weekend of reading. Passive investors can use this strategy without professional help, and very little time invested.

Active investing requires a significant time commitment. This is a professional sport, even most professionals failing to beat the passive investors a lot of the time.

Even hiring a professional for active investing requires a fair amount of expertise. How do you choose a fund manager? Last years winners are renowned for being next years losers. Picking the next winning fund manager is almost as hard as picking the winning stock itself!

Fees

Actively managed funds tend to charge far higher fees than passive funds. Even if the fund manages to beat the index, fees eat into the returns.

Active management means funds are brought and sold more often. Passive funds are generally held for the long term. Trading creates more fees, and this is significant.

As a result of reduced trading, Fidelity found their best-performing investors had actually died or forgotten about their accounts! Increased trading frequency is a predictor of poorer returns.

Minimising fees is critical to improving performance.

Results

Warren Buffett’s won his famous bet in 2007 that a broad index fund would beat the 10-year prospective returns of 5 hedge funds.

Research since has confirmed the damning news for fund managers – passive investing is cheaper, easier and provides better returns most of the time.

The SPIVA score card has been reporting on active vs passive returns for the past 20 years. Here is a quote from their latest report:

“While the turmoil and disruption caused by the pandemic should have offered numerous opportunities for outperformance (by active managers), 57% of domestic equity funds lagged the S&P Composite 1500 index during the one-year period ended Dec. 31, 2020.”

SPIVA Report Card 2020

The Australian stock market is tiny in comparison with the US. It is also known to be highly concentrated in the banking and mining sectors.

With Aussie passive funds being so concentrated in a couple of industries, surely active management could outperform them?

According to SPIVA’s international data for Australia over the past 20 years, ~50% or more of active funds were outperformed by the ASX 200. And these are professionally managed funds, not amateur investors.

Why Do Investors Still Love Active Investing?

Passive investing is about as exciting as watching paint dry! It’s a strategy best suited to those who want the best returns, and are happy not to fiddle with their investments.

Active investing is intellectually challenging and has potentially infinite returns when it works out. Looking back at the 12,000%+ growth of Amazon stock since its Initial Public Offering (IPO) gets investors salivating! Greed and impatience tempt new investors to try and pick the next “amazon”.

The stock market is a device to transfer money from the impatient to the patient.

Warren Buffett

Returning “Alpha” means beating index returns, and it seems so easy. You can even find an investing newsletter to give you tips on which to buy.

Of course, if the newsletter producers could predict the next big thing, they probably wouldn’t be aggressively marketing their newsletter at you.

Similar to how we often feel safer driving our cars than being an airline passenger, active investing can provide a false sense of control.

Evidence Based Investing

This is a term that I am hearing with increasing frequency. Investing decisions are based on a set of predetermined rules, and actions led by results from academic investing research. The idea is to remove the subjectivity from active investing. Sounds great!

Or perhaps too good to be true?

Most non-physicians would assume we follow evidence-based medicine all the time.

The reality is that the evidence behind our management of disease is lacking, patchy, inconsistent, and difficult to interpret.

The evidence we read may or may not be relevant to the patient in front of us, due to an almost infinite number of variables.

Much of this research is funded by the very drug companies that stand to profit from a particular result. And it is well documented that journals rarely publish negative results, introducing more bias.

On reading a research paper providing evidence for a new treatment, the team looking after the patient need to consider all the above factors before deciding whether this new evidence should change practice. This requires skill, experience and involves far more subjectivity than is ideal.

Interpreting and applying investing evidence to investing decisions will also involve skill and plenty of subjectivity. It will be difficult to research whether “evidence-based investing” actually works, given the likely high variability in it’s application.

Active vs Passive Investing

Passive investing is cheap, easy and likely to give you a better return than active investing. It’s hard to argue with that. It is boring though, and that’s what puts people off.

Those with less of an interest in all things financial probably have an advantage here. They can work out a plan, set up a direct debit and forget about their investments.

They will probably do far better than those tempted to always checking their accounts, and looking for investing opportunities.

“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”

Warren Buffett, 1993

Ready to make the next move? Find out how to choose an ETF portfolio

Aussie Doc Freedom is not a financial adviser and does need offer any advice.  Information on this website is purely a description of my experiences and learning.  Please check with your independent financial adviser or accountant before making any changes.

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