Passive and Active Investing Strategies

By Casper Shoghi

English 3003

Jami Barnett

TABLE OF CONTENTS

Abstract…………………………………………………………………………………………1

Executive Summary……………………………………………………………………………1

Introduction…………………………………………………………………………………….2

Methods…………………………………………………………………………………………3

Results…………………………………………………………………………………………..3

The Passive Argument…………………………………………………………………3

The Active Argument…………………………………………………………………..4

Conclusion………………………………………………………………………………………5

Glossary…………………………………………………………………………………………8

Works Cited…………………………………………………………………………………….9

LIST OF ILLUSTRATIONS

Portfolio Returns vs. Index Returns………………………………………………………….4

Rolling 12-Month Returns for S&P 500 ……………………………………………………..5

MEMOTO: Readers in Finance field and finance majors

FROM: Casper Shoghi

SUBJECT: Research Report

DATE: March 26, 2013

ABSTRACTIn the world of portfolio* management, the debate between active and passive investing strategies is ongoing between investors and portfolio managers. Passive investing is a long-term strategy in which investors typically purchase securities without the expectation of immediate returns. Rather, passive investors hold the belief that in the long-run, their investments will be more profitable. This strategy is typically achieved by investing in index funds. An index fund is a fund that very closely mirrors the returns on a stock index such as the S&P 500. Active investors look more for short-term profits and monitor investments much more closely. Active investors often seek to exploit inefficiencies in the market such as improperly priced securities and profit from these errors. The argument in favor of active investing typically states that the index returns can be beat, whereas passive investors are of the belief that the index cannot be beat consistently and will not be beat by enough to justify the cost of active investing. Using the online database EBSCOhost, research was conducted and scholarly articles were pulled from the database to examine the arguments in favor of both strategies. This report will further explore and compare the arguments in favor of active and passive investing strategies.

EXECUTIVE SUMMARYIn the world of portfolio management, the debate between active and passive investing strategies is ongoing between investors and portfolio managers. The argument in favor of active investing typically states that the index returns can be beat, whereas passive investors are of the belief that the index cannot be beat consistently and will not be beat by enough to justify the extra costs of active investing. These additional costs come from more research, advertisement, and trading. Passive managers argue that active managers that do beat the index consistently are nearly impossible to find, and yet, active managers point out investors’ knack for finding them. Active managers also accuse passive managers of being victims of time-bias in their studies. It appears that active and passive investing strategies both provide valid arguments for why to invest in their chosen strategies. Using the online database EBSCOhost, research was conducted and scholarly articles were pulled from the database to examine the arguments in favor of both strategies. This report will further explore and compare the arguments in favor of active and passive investing strategies.

INTRODUCTIONIn the world of investing, two broad investment strategies exist. These strategies are passive and active investing. Passive investing is a long-term strategy in which a stock or portfolio of stocks will be held for the long-term. A passive investor does not seek to profit from the daily changes in price and believes that the “sit-and-wait” strategy will be more profitable in the end. On the other hand, active investing is a short-term strategy. Instead of purchasing a stock and waiting for it to increase in value over a long period of time, active investors are closely monitoring their investments to exploit smaller changes in price.

Passive investing strategies are relatively new to the world of portfolio management while active investing has been around since investing began. Passive investing strategies originated “in the 1950s and ‘60s, culminating in the launch of the first stock-index fund in 1973” (Gardner 22). Since the inception of passive strategies, investment strategies have since begun to shift from active strategies to passive strategies. This shift is partly because of the benchmarks being used to evaluate portfolio managers and make them more accountable for their performance. Relative to benchmarks, passive strategies lead to a decrease in uncertainty in a portfolio’s returns (Bird and Woolley 303). These reasons are why this argument has come into the investment field.

The purpose of this report is to investigate the pros and cons of each strategy and compare the two different views of whether an active or passive strategy will lead to more investment success. Making a recommendation as to which strategy to use is beyond the scope of this report. Instead, the report demonstrates how many of the points of argument between passive and active investors are countered by the other. Both sides present highly sensible and viable arguments and so a conclusion favoring one is not possible within the scope of this research.

Three sources were found and used that argue in favor of passive investing strategies compared to active strategies. In the article “Passive Investing: A Second Look,” Chris Gardner defends passive investing by attempting to counter some of the arguments active investors make against passive investing. After providing this information, he then provides some broader, bulleted points to end the argument in favor of passive. Next, Lee Hull also favors passive investing in his article “Is Active Investing Better Than Passive Investing?”, but not before providing reasons as to why people incorrectly compare active and passive investing strategies. Finally, Conrad De Aenlle more concisely illustrates why passive investing wins in his article “In Investing, Passive Beats Active.” Much of the information gathered by De Aenlle comes from interviews from an analyst at Morningstar and financial planners.

Two articles were primarily used to argue for active investing strategies. In his article, “Passive Investing: The Emperor Exposed?” Christopher Carosa aims to disprove many of the reasons many investors swear by passive strategies. He believes that the passive versus active management debate is victim to two crucial flaws that provide a strong case in favor of active investing. These flaws will be discussed later in the report. Ron Bird and Paul Woolley provide a case for active investing that focuses more on the economic effects of passive investing in their article “Economic Implications of Passive Investing.” Though Bird and Woolley do not tend to recommend active investing as much, they provide reasons as to how the trend of moving from active to passive strategies could hurt the economy as well as investors.

The findings of this research do not allow for a recommendation to be made in favor of active or passive investing, but important factors were found for both sides. In favor of passive investing, managers argue that active investing is just too expensive for the amount of returns one receives. Passive managers believe that active managers will not consistently beat the market to justify those fees and that even if some did, they would be very difficult to find. Active managers argue that historically, many do, in fact, find these active managers beating the market. They also argue that passive investing may have negative effects on the economy as a whole.

The results of this research will be organized in two sections. The first section will provide the argument in favor of passive investing. The second section will do the same in favor of active investing. Throughout the research, it became evident that the comparison of the two is not without its flaws and that the better strategy may vary from investor to investor. This will be explored in the conclusion which will also provide more comparison of the two strategies and how the articles seek to discredit the points of the opposing views.

METHODSIn order to explore the topic of active and passive investing strategies and their differences, research was conducted via the EBSCOhost database to find articles on these strategies. The criteria for selecting articles are as follows. First, the articles had to be scholarly, written by those with higher education or vast knowledge in the field, and from a reputable source. Second, the articles had to take a side in the passive versus active debate. The articles had to choose a side because the intent of this report is to examine the discussion between both sides and thus, any article in the middle of the spectrum would not be conducive in exploring this disagreement and the often antagonizing dissent.

Once the articles were found, they were examined primarily for the reasons in which the authors believed their chosen strategy was better than the other. These reasons were pulled from the articles to be used in the results section of this paper. The points were also compared for agreements within passive and active investors, respectively, for the sake of consistency between those who chose the same strategy in order to ensure one consistent argument from multiple authors.

From here, the arguments were compared and contrasted to each other to clarify the argument and to demonstrate how both sides relate to each other. This comparison was done with the idea that the reader would be able to understand how the two sides compare and how they counter the other’s argument. Then, the reader will be better equipped to formulate his or her own recommendation as to whether to invest passively or actively.

RESULTSTHE PASSIVE ARGUMENTAs previously stated, passive investing strategies have increased in popularity amongst investors due to reasons the investors find convincing. Passive index funds “are funds that are very low cost and designed to track a certain market index” (Hull 67). The tracking of a market index means that the returns of the fund closely mirror the returns of an index. The chart titled “Portfolio Returns vs. Index Returns” shows the similar monthly returns on an index fund portfolio and the S&P 500 index from the period of January 2010 – October 2012. As one can

see, the portfolio’s movements echo that of the index very closely and the percent per month returns are nearly the same with the portfolio slightly beating the index.

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15 Portfolio Returns vs. Index Returns

PortfolioIndex

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Shoghi, Casper E. "Portfolio Management: Project 4."

Compared to the low cost it takes to manage index funds, actively managed funds have higher costs for three reasons. First, actively managed funds require more research and more intensive research costing managers more because managers have to pay the analyzers for the extra work. Secondly, these funds “tend to have higher trading costs* “because they buy and sell more frequently” (De Aenlle 1). And lastly, it costs managers more “for marketing to tell the world how wonderful their funds are” (De Aenlle 1).

Active managers experiencing underperformance of their funds have blamed it on passive investing, and since the introduction of passive investing “active managers were consistently underperforming their true benchmarks*” (Gardner 22). These managers are accusing “the index-fund tail of wagging the stock-market dog” (Gardner 22). However, a study by Burton Malkiel and Aleksander Radisich in 2001 found that “the flow of money into the index funds was totally unrelated to relative performance” and that “the underperformance of active managers is fully explained by the extra costs they incur in their efforts to beat the market” (Gardner 22).

There are, however, active managers that do very well, and active managers have said that passive investors ‘ignore the “exceptional” manager’ (Gardner 67). Despite this, selecting a manager that could consistently beat the index is nearly an impossible feat, and the idea that one investor could actually profit consistently from the errors of others is difficult to imagine (Gardner 22).

THE ACTIVE ARGUMENTActive investors provide many reasons for the continued use of active investing strategies. It is completely possible to locate “talented managers in any corner of the market who are not overburdened by high expense ratios and have a proven ability to beat benchmarks over time” (De Aenlle 1). The additional costs of active investing incurred for one of these managers is offset because investors “have exhibited a consistent track record of investing in U.S. equity funds that are more likely to outperform the S&P 500” (Carosa 62).

Passive investors could also be examining a specific time period and thus, be falling victim to period-dependent bias. By using rolling 12-month returns (thus, eliminating any time period bias) and a period of time from January 1975 to June 2004, it was found that the active funds defeated the S&P 500 index about two-thirds of the time (Carosa 58). The table titled “Rolling 12-Month Returns for S&P 500” provides visual representation of this study.

Carosa, Christopher. "Passive Investing: The Emperor Exposed?" 

Returns just beating the index are not enough, however. A study by Christopher Carosa found that not only did U.S. equity funds beat the index, but that the statistical “certainty level is large enough to suggest the possibility of a statistically significant difference between the U.S. equity mutual fund returns and the S&P 500 returns” (Carosa 60).

Since passive investors most frequently create index funds to follow the market, the stocks chosen to invest are typically more varied in their performance since there is much less research conducted. Unlike active investors who believe in inefficiency in the market and exploiting arbitrage* opportunities, passive investors “accept without demur the prices and quantities of stock supplied by issuers of stocks contained in the index” (Bird and Woolley 307). With greater investment in less profitable stocks and the trust passive investors have with the market, passive managers are misallocating resources “resulting in lower economic growth and market returns along with greater volatility associated with market bubbles” (Bird and Woolley 310). For this reason, many of the investments made by passive managers are thought to be economically wasteful in that greater investment in poor stocks hurts the economy. Additionally, if the market goes down drastically, index fund managers will see their funds mirror this downfall.

CONCLUSIONThe arguments in favor of active and passive investing strategies are both very convincing. It would appear that both strategies are not without their flaws. Passive investors insisting that most active investors do not consistently beat the index leads one to believe that a passive strategy may be more beneficial than an active strategy. However, active managers counter by saying that some active managers do consistently beat the index and that investors have shown a strong ability to find these managers’ funds. From there, passive strategists claim that the added costs of active management such as advertising and more frequent trading costs lead to profits that can similarly be achieved or defeated by passive strategies.

Passive managers also seem to unanimously agree that active managers underperform their benchmarks, and dismiss the notion that it is the fault of their funds as many active managers would claim. However, active managers counter by saying that actively managed funds beat the index the majority of the time, and accuse passive managers of falling victim to drawing conclusions from too small a span of time. Additionally, passive strategists do not believe the active strategist that can beat the index can be easily found, but active strategists insist that investors have historically done so.

As more investors shift to passive strategies, the argument between passive and active strategists is sure to continue. With the research conducted in this report, a recommendation in favor of either strategy cannot be made. Rather, the recommendation that either can be a successful strategy and that it depends on the personal preferences of investors can be made.

Glossary (Defintions from Investopedia.com)

Arbitrage - The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time.

Benchmarks - A standard against which the performance of a security, mutual fund or investment manager can be measured. Generally, broad market and market-segment stock and bond indexes are used for this purpose.

Portfolio - A grouping of financial assets such as stocks, bonds and cash equivalents, as well as their mutual, exchange-traded and closed-fund counterparts. Portfolios are held directly by investors and/or managed by financial professionals.

Trading Costs - Expenses incurred when buying or selling securities. Trading costs include brokers' commissions and spreads (the difference between the price the dealer paid for a security and the price the buyer pays).

Works Cited

Bird, Ron, and Paul Woolley. "Economic Implications of Passive Investing." EBSCOhost. N.p.,

30 Sept. 2002. Web. 26 Mar. 2013.

<http://0-web.ebscohost.com.library.utulsa.edu/ehost/pdfviewer/pdfviewer?sid=c6d62845-

2372-4325-bef8-262e01619fda%40sessionmgr10&vid=11&hid=27>.

Carosa, Christopher. "Passive Investing: The Emperor Exposed?" EBSCOhost. N.p., Oct. 2005.

Web. 26 Mar. 2013.

<http://0-web.ebscohost.com.library.utulsa.edu/ehost/pdfviewer/pdfviewer?sid=c6d62845-

2372-4325-bef8-262e01619fda%40sessionmgr10&vid=9&hid=27>.

De Aenlle, Conrad. "In Investing, Passive Beats Active." New York Times 12 May 2007: C6(L).

Business Insights: Essentials. Web. 25 Mar. 2013.

Gardner, Chris. "Passive Investing: A Second Look." EBSCOhost. N.p., 14 Feb. 2003. Web. 27

Mar. 2013. <http://0-web.ebscohost.com.library.utulsa.edu/ehost/detail?

vid=6&sid=c6d62845-2372-4325-bef8-262e01619fda

%40sessionmgr10&hid=27&bdata=JnNpdGU9ZWhvc3QtbGl2ZQ%3d

%3d#db=bwh&AN=9136107>.

Hull, Lee. "Is Active Investing Better than Passive Investing?" EBSCOhost. N.p., Sept. 2011.

Web. <http://0-web.ebscohost.com.library.utulsa.edu/ehost/pdfviewer/pdfviewer?

sid=ff6d8c97-a442-4a8c-a70d-a3c2a150f49a%40sessionmgr13&vid=11&hid=9>.

Investopedia. N.p., n.d. Web. 31 Mar. 2013. <http://www.investopedia.com/>.

Shoghi, Casper E. "Portfolio Management: Project 4." 4 Apr. 2013.