Active investing or passive investing – Which is better?

Active investing is where managers buy and sell investments and their two main benchmarks are whether they can outperform other managers and whether they can outperform the appropriate index.  Despite the great effort from active managers, there is a continued debate about whether active investing can actually beat passive investing.

The long-term impact of fees

Before we jump into the debate, we must understand that all active investing starts off with a disadvantage.  If we pretend that there is a race to the finish line between an active manager and an passive manager, the active manager starts with 2.5 pound ankle weights (representing the higher fees they have to carry to the finish line.  In a short sprint, good runners might be able to overcome the disadvantage.  However, wearing that 2.5 pound weight can be a real disadvantage the longer the race goes.  The odds of winning in a marathon with that handicap decrease dramatically.  What if the weight was 3 pounds or 5 pounds or more?  What if the active manager had to pull a tire equivalent to 33% of your body weight.  How competitive would he or she be?

Here’s some calculations that may make you think about the long term cost of fees

Let’s compare 2 investments.  The first investment has a 2.5% annual fee while the second investment has a 1.5% annual fee.  Let’s assume both investments have the same gross return of 6%.  Here’s how the two investments look after 25 years

AFTER 25 YEARS

Investment 1

Investment 2

Total Contributions:

$10,000.00

$10,000.00

TOTAL FEES PAID

$10,118.20

$6,999.56

30.82%

Actual Value after fees:

$22,790.93

$29,413.89

$6,622.96

On a $10,000 investment, that’s an extra $6,622.96 in your pocket instead of someone else’s.

Let’s now assume the target net return is 4%.  The first investment with a 2.5% fee must now produce a gross return of 6.5% while the second investment only has to produce a target return of 5.5%.

After 25 years, they should have the same net amount because the net return after fees is the same.  However, the first investment had to work much harder to get to the same place because it had to overcome 40% more in fees.

AFTER 25 YEARS

Scenario 1

Scenario 2

Total Contributions:

$10,000.00

$10,000.00

TOTAL FEES PAID

$10,848.65

$6,517.71

39.92%

Actual Value after fees:

$25,636.31

$26,134.68

$498.37

Does active investing justify higher fees?

The financial industry may be quick to jump in on the flaws of this analysis suggesting that a fee of 2.5% may be justified if they can deliver higher returns as a result of adding value though active management of the investment – better research, buying low and selling high, and adjusting portfolio allocations.

This may sound like a great story but statistics would suggest otherwise.  According to the Standard and Poors Indices versus Active Funds Scorecard (SPIVA) only 19.6% of Canadian Equity Funds were able to outperform the S&P/TSX in 2010.  The number decreases over 3 and 5 year periods to 11% and 2.5% respectively.  Passive investing has done much better.

  Comparison Index

One-Year

Three- Year

Five- Year

Canadian Equity S&P/TSX Composite Total Return

19.64%

10.94%

2.53%

Canadian Small/Mid Cap Equity S&P/TSX Completion Total Return

32.56%

18.52%

28.57%

Canadian Dividend & Income Equity S&P/TSX Canadian Dividend Aristocrats Total Return

10.35%

6.45%

0%

U.S. Equity S&P 500 Total Return Index C$

35.21%

21.59%

14.13%

International Equity S&P EPAC LargeMidCap Total Return C$

9.30%

16.67%

11.63%

Global Equity S&P Developed LargeMidCap Total Return C$

5.77%

14.66%

15.44%

Source: Standard & Poor’s. Data current as of December 31, 2010. Charts are provided for illustrative purposes. Past performance is not a guarantee of future results.

In all categories the odds of active managers beating passive investing are low which gives the advantage to passive investors.

How much better does passive investing do?

If we go back to the SPIVA report, the data shows that for Canadian Equity funds, the index outperforms the average of all Canadian Equities by 2.6% to 3.05%.

Report 3: Equal-Weighted Fund Returns, Year End 2010

One-Year

Three-Year (Annualized)

Five-Year (Annualized)

Canadian Equity

14.56%

-0.51%

3.88%

S&P/TSX Composite Total Return

17.61%

2.09%

6.51%

3.05%

2.60%

2.63%

How much of this difference in this example has to do with the fact that mutual funds charge management fees (average 2.5%)?  I would say fees definitely have something to do with the difference.  Since the data is simplistic, it can be dangerous to jump to the conclusion that fees are the only cause for the underperformance of mutual funds compared to the index.

I also did my own comparison of Canadian Equity funds to the benchmark over different time frames and the results were very similar.   You can check out the charts and data at Mutual Funds underperform the benchmark.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace.For more information you can follow him on Twitter @JimYih or visit his other websites Group Benefits Online and Advisor Think Box.

16 Responses to Active investing or passive investing – Which is better?

  1. Ellen says:

    Great post Jim. I really want to make the switch to passive investing, but am trying to decide if it’s worth making the jump or I should wait. If I leave now, I’m out about 3 grand thanks to deferred service charges (I’ve certainly learned the hard way my financial advisor is..not a great guy.). But part of me just wants to jump ship and get it done and over with.

    • Jim Yih says:

      Those darn deferred Sales Charges. The mathematical perspective is to look at how much money you will save on an annual basis with lower fees and see how long it takes to recoup the one time DSC. In fact, that might be a good article for the future! Want to send me some numbers?

  2. James says:

    I’ve been struggling with the whole passive vs active as well lately. I’ve always been an advocate of active investing using above average managers and below average cost. I’m curious how the above comparisons would narrow if you added some fees to the index (as I’m unaware of a place to buy index funds with no fee), dropped the bottom half of 10 year performers from the Canadian Equity, and considered the ability to use lower fees and deductibility for higher account values (over $100k). I don’t actually know the answer, but am curious.

  3. I like passive investing because active management can’t beat passive consistently anyway. Most of my mutual funds and ETFs are passive index. My dividend portfolio are comprised of individual stocks and I’m mostly inactive there as well.

    • Jim Yih says:

      Thanks for the comment. Is it the fees or the passive management that gives the edge? Probably both since there is a correlation between fees and indexing.

      • Muhamad says:

        Yes, you can invest with an American innemtsevt account, as long as you comply with certain regulations. Here is a direct quote from my broker/dealer: Non-Resident Alien: An individual who is not a citizen and who does not have his permanent (tax) residency in the United States. A nonresident alien is subject to 30% NRA withholding on some types of U.S. income, and he must file a nonresident tax return on that income. The U.S. has tax treaties with many countries allowing a resident of any of these countries to claim reduced rates of withholding. A nonresident alien is required to file an original W-8BEN with the payer or he will be treated as a U.S citizen and be subject to backup withholding according to TEFRA rules. Here is a list of countries that the U.S. has sanctions against, with the date the sanctions were instituted. Residents of these countries may not have an American innemtsevt account:OFAC Country Sanctions Programs Program Last Updated: Balkans Sanctions 05/22/2006 Belarus Sanctions 02/27/2007 Burma Sanctions 05/22/2006 Cote d’Ivoire (Ivory Coast) 09/19/2006 Cuba Sanctions 05/23/2007 Democractic Republic of the Congo Sanctions 03/30/2007 Iran Sanctions 04/04/2007 Iraq Sanctions 07/21/2005 Former Liberian Regime of Charles Taylor Sanctions 05/23/2007 North Korea Sanctions 02/02/2007 Sudan Sanctions 04/04/2007 Syria Sanctions 08/15/2006 Zimbabwe Sanctions 05/22/2006

  4. david toyne says:

    The decompounding effect of high fees is truly staggering and more Canadians need to care about this element of investing.
    Michael James on Money adds another important dimension to this debate when he considers Steadyhand – The Behaviour Gap. http://michaeljamesmoney.blogspot.ca/2012/02/evaluating-steadyhand.html

    Also, at the risk of appearing too self serving in this blog comment, I do want people to know that we released a report comparing the ETF investor’s experience to Steadyhand that might provide some further insights into the issues.

    http://www.steadyhand.com/asset/2011/11/07/steadyhand%20vs%20etfs.pdf

    • Jim Yih says:

      That was a great article David and worth sharing with others. Steadyhand is pretty unique in many ways. Sometimes the generalization make it difficult for unique managers like Steadyhand.

  5. Gary Gorr says:

    This is a tiring question and there are arguments to be made on both sides. Your math may be correct but it ignores several other factors like behaviour and the impact it has on wealth accumulation.

    Here is an alternative case that I make.http://gbgorr.wordpress.com/2012/03/14/the-case-for-active-management/

    • Jim Yih says:

      Thanks for the comment Gary

      For me, it’s not an either or when it comes to behavior vs fees. It’s both. Watch your behavior and watch the fees you are paying.

      It’s a tiring question because despite the data, the attention and the question being posed over and over again, more people are investing in higher fee actively managed products.

      I still think it’s worth revisiting.

  6. Good post.

    Like Joe, I like passive investing because I can pretty much turn off my brain with part of my portfolio, with broad-market ETFs.

    I do like owning dividend-paying stocks and so with some 25 now in my portfolio, 20 of them Canadian, I’m becoming almost an indexer with those holdings as well, except I pay no money management fees, only the very odd commission fee.

    Mark

  7. Alan Fustey says:

    Jim
    Good post. The debate regarding the merits of active vs. passive management was answered many years ago by Nobel Laureate William Sharpe in his 1991 paper “The Arithmetic of Active Management”.

    Sharpe concluded:
    “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

    Your readers can read the paper at the following link:
    http://www.stanford.edu/~wfsharpe/art/active/active.htm

  8. Ellen says:

    Hey Jim – that’s really nice of you to offer. I am still trying to get some information out of my @##$# advisor, but once I do, then yes, I’d be happy to. Thank you!

  9. Patrick says:

    What about finding and investing in the 19.6%/11%/2.5% actively managed funds that do perform better than the Index over 1/3/5 years, Jim? Granted “past performance is no guarantee of future results”, is there no place for actively managed mutual funds in one’s investment portfolio?

    Thanks.

  10. I almost get a lot of questions/confusion about what actually constitutes passive investing. A lot of folks think that it involves picking dividend stocks or creating passive income.

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