165: Active vs. Passive Investing: Which Is Better?

Welcome to The Invested Dads Podcast, simplifying financial topics so that you can take action and make your financial situation better. Helping you to understand the current world of financial planning and investments, here are your hosts, Josh Robb and Austin Wilson.

Austin Wilson:

All right. Hey, hey, hey. Welcome back to The Invested Dads Podcast, a podcast where we take you on a journey to better your financial future. I am Austin Wilson, research analyst at Hixon Zuercher Capital Management.

Josh Robb:

And I’m Josh Robb, Director of Wealth Management here at Hixon Zuercher Capital Management.

Austin Wilson:

We would love it, if you’re not already subscribed, if you’d subscribe and visit our website. You can sign up for our weekly newsletter to get notified each and every Thursday when our new episode drops.

Josh Robb:

So today, Josh.

Austin Wilson:

Yes.

Josh Robb:

We are going to be boxing. We are having a verbal sparring match.

Austin Wilson:

That’s right. No, actually, I think we’re going to agree on a lot of this.

Josh Robb:

Oh, you may be surprised.

Austin Wilson:

I know. That’s actually, that’s probably true. Reminds me, I saw this Facebook Reel. That’s taking over the world now.

Josh Robb:

Facebook Reels are?

Austin Wilson:

Yeah, TikTok’s not the thing. Facebook Reels are.

Josh Robb:

That’s it. That’s it.

Austin Wilson:

It was a reel. It really nice.

Josh Robb:

There it is.

Austin Wilson:

It was a video of a 600-pound, no joke. UFC fighter.

Josh Robb:

Okay.

Austin Wilson:

That’s a big guy.

Josh Robb:

600 pounds?

Austin Wilson:

600 pounds, fighting a 168-pound UFC fighter.

Josh Robb:

Are they the same weight class?

Austin Wilson:

No, but they just had a match.

Josh Robb:

Okay.

Austin Wilson:

I don’t know why. I didn’t watch the whole thing, admittedly, because it was like 18 minutes.

Josh Robb:

Yeah, yup.

Austin Wilson:

But the little guy, not little. They’re a normal size human.

Josh Robb:

I mean, yeah, 170 pounds, yeah.

Austin Wilson:

Was just trying to wear out this guy.

Josh Robb:

Oh yeah.

Austin Wilson:

Just trying to run around, make him follow him.

Josh Robb:

Yeah. Yeah.

Austin Wilson:

And I didn’t watch at the end, but I’m assuming he actually put up a good fight if it lasted 18 minutes.

Josh Robb:

So yeah.

Austin Wilson:

So anyway, this is-

Josh Robb:

Impressive.

Austin Wilson:

… that’s boxing. That’s not boxing. That’s UFC, but that’s fighting.

We’re going to have a little battle royale here debating the difference between active investing and passive investing. And again, debating might be a bit of a stretch, but we’re going to have a lot of discussion around the benefits and pitfalls of each kind of investing strategy. There are going to be areas where we disagree, areas where we agree. We want to give you, our listeners, the information so that you can make the decision on what is best for you in your situation.

 

[2:14] – What is Active & Passive Investing?

 Austin Wilson:

So let’s set the stage for what we’re talking about today.

Josh Robb:

All right, sounds good.

Austin Wilson:

So active investing, active, keyword here, as it’s name implies, it’s a hands-on approach. So, meaning someone is a portfolio manager. They’re managing a portfolio, picking things like stocks, even bonds, whatever that may be. The goal of this sort of management type, active investing, is to beat the market, beat the stock market or the bond market over time and taking advantage of short-term price fluctuations where you can get a little bit of a disconnect.

Something’s cheaper than you think it’s worth? You can take advantage of that. Something’s more expensive than you think it’s worth? You can sell and take advantage of that. So that is involving a much deeper analysis than what we’re going to talk about in a little bit when it comes to passive. But you must know the companies, know what they’re worth, know what their financials are going to be, know all of the risks and opportunities around them. This can be really managed in a couple different ways. Quantitative is rules-based. You can use qualitative, which is fundamental-based investing.

And then, the tricky part is you have to try and time buying and selling things at different times and that’s what you’re going to do as a manager, as a portfolio manager, to try and beat the market over time. So that really requires confidence that you’re going to know when it’s the right time to do those things. And ideally, a lot of investors who like active management take a little bit longer time horizon to look at how a portfolio manages over long terms, but that is active investing.

Josh Robb:

Now active… you mentioned trying to beat the benchmark, but sometimes, active management may not be beating a benchmark, but focusing on an objective.

Austin Wilson:

That’s true.

Josh Robb:

So, for instance, you could have an active manager who says, “I’m going to invest in stocks, but all my stocks have to meet this criteria.” So that’s a version of active management in that maybe or maybe you don’t get the benchmark because depending on what you use as a benchmark, you could have like the S&P 500. But if it’s a ESG fund, you may or may not beat it, but from an active standpoint, you’re screening or adjusting your portfolio to a criteria.

Austin Wilson:

Absolutely.

Josh Robb:

Okay.

Austin Wilson:

And another note is that active managers are sometimes wrong. They time things wrong. They do things wrong. They make a bad choice to buy or sell something, right? So over a long time period, the goal of active managers is to be more often right. You’re not going to be 100%, more often right than wrong in your overall thing. Okay, so that’s active.

Now, passive investing, you’re really looking at long-term investments. You’re not wanting any creativity. You’re just wanting to essentially buy the market. You are looking to limit the amount of buying and selling you’re doing within portfolios, and you’re just going to own the market. This is a very cost-effective way to invest because there’s really no portfolio managers, essentially. Maybe it’s a mutual fund or an ETF that they are just buying the market all the time. So no one really needs… there is not a big deep group of analysts. There’s no big expensive portfolio managers. You’re essentially just buying the market at market waiting’s all the time.

So passive investing is really a buy and hold mentality to buy and hold the market over all the time and takes the pressure off of trying to time the market right because a lot of active investing, people think that they are fighting market inefficiencies or good opportunities here or risks here or whatever. You’re just buying the market all the time with passive investing. So managers aren’t anticipating how the market’s going to move and positioning in that way. You’re just buying the market all the time. The most basic example of this is like an S&P 500 index fund. You’re buying the S&P 500, essentially. 505 names. You’re buying the market at market waitings all the time. So that is passive managers there.

So really, what’s happening is a lot of people will use passive as their core holding. They’re saying, “I’m holding the market. I know I’m going to get market returns over time. I’m holding teeny, teeny, teeny pieces of a lot of companies, so I have a lot of diversification, which means my risk, my active risk is very low and I’m going to get market returns.” So that’s kind of the thinking of passive investing over time. And a lot of retirement plans, 401(k) plans, things like that are generally put into things like passive index funds is a common word for that. Using the S&P 500, again, as probably the prime example of a S&P 500 index fund. You’re owning the market. So you’re going to get the market returns over time and that is passive investing.

Now, where things are a little different is where a manager in an active fund or active investment of some sort is going to have the ability to change their holdings if they see a downturn coming or a risk or whatever. If you’re holding the market or passive investment in general, you’re holding it through it all and you don’t try and time those things as a portfolio manager would. That’s passive. It’s just, essentially, you own the market. Active, you have someone picking stocks or bonds for you that’s going to look different than the market. That is the difference between active and passive.

 

[7:09] – The Efficient-Market Hypothesis Debate

 And a lot of this boils down to a discussion around the efficient-market hypothesis. Ooh, big word, right? Also known as EMH. We love our acronyms. It really is a theory that the share prices in the stock market or the bond market, I guess, for that matter, they reflect all information that is available right now and that it’s very, very difficult, even impossible, to generate better returns over the long-term than the market. Now, this is a very popular debate in active versus passive discussions because active managers would say, “We can generate alpha returns above and beyond the market over time.” Passive-favoring investors would say, “That seems unlikely because the market’s efficient.”

According to the efficient-market hypothesis, stocks always trade at their fair value on exchanges, so in the stock market right now. So it’s really impossible for investors to buy stocks that are too cheap or sell stocks that are too expensive. So the market’s always perfectly efficient according to this theory. Again, therefore, market timing, very impossible. You can’t do that if everything’s trading at fair value at any given time. That is a reason that a lot of people cling to passive investing because they believe the markets are perfectly efficient.

Josh Robb:

Now, if I remember my studying, there’s kind of a scale of this. It’s just not an all or nothing.

Austin Wilson:

Yes. There are varying –

Josh Robb:

And so there’s some that say, “You know what? It’s mostly efficient. When the data comes out, there’s a slight delay, but it is digested and represented in the price in a pretty efficient manner.”

Austin Wilson:

Correct.

Josh Robb:

And so that’s where you say, “Well, there’s the opportunity for people to capture that before they digest it.”

Austin Wilson:

In the short-term.

Josh Robb:

And then, there’s the totally efficient market, where you just described, where they say, “No.” Instantaneously, when that is known, it’s automatically priced in and it’s next impossible to do anything. Okay.

Austin Wilson:

Absolutely.

Josh Robb:

So passive people say the price reflects all known data. Active investors say there’s either a delay or some data isn’t priced in efficiently.

Austin Wilson:

Something isn’t efficient. Yup.

Josh Robb:

And so there’s the ability to offset. Okay, perfect. Thank you for describing those two, and we’re going to talk through our thoughts on those.

 

[9:13] – Dad Joke of the Week

But before we do, I have a dad joke.

Austin Wilson:

Ooh, bring it.

Josh Robb:

It’s a question for you. Do you know the difference between men and investment bonds?

Austin Wilson:

Maybe not.

Josh Robb:

Well, at some point, bonds mature. I saw that, thought of that. That’s probably true for the most part, so…

 

[9:34] – Advantages & Disadvantages of Active Vs. Passive Investing

 Austin Wilson:

All right, let’s talk about some advantages and disadvantages to both kinds of investing so that you can make, again, the best investment decision for your particular situation. Talked about active first. Active has its advantages, for sure. One of those is flexibility. So it’s very flexible because active managers are not required to follow an index. In fact, they want to look different than the index. Otherwise, they’re going to get index returns and you can’t outperform if you’re buying the index.

Josh Robb:

What’s that term for when someone says they’re active, but they’re really passive?

Austin Wilson:

The index hugger?

Josh Robb:

Yeah.

Austin Wilson:

Something like that?

Josh Robb:

Yeah, something like that.

Austin Wilson:

Yeah.

Josh Robb:

Secret passive.

Austin Wilson:

Yeah. So yeah, like closet passive.

Josh Robb:

Yeah, that’s it.

Austin Wilson:

Yeah, exactly. A lot of active managers think they can buy diamond in the rough stocks and that’s something that maybe you’ll take an outsized position in a smaller company, bigger than the market would hold, and that’s your opportunity to generate some flexibility and hopefully, some alpha over time.

Another one is hedging. So there are certain ways within different kinds of portfolios where you can hedge or take risk off the table. You can buy options to really offset your longer stock positions. You can have a position in cash. The market’s not going to have a position in cash. You can sell stocks short. We’re not going to get into all these derivatives and options and things like that, but they have the flexibility to do some of this, which is a way to potentially protect some of their gains or take risk off the table or, in some instances, increase risk actually.

Josh Robb:

Yeah.

Austin Wilson:

Another benefit of active management is tax management. So even though active management could generate capital gains taxes, advisors can tailor tax management strategies to individual investors by selling investments that are losing money to offset the taxes on the big winners. So like even portfolio managers will often not have to distribute as much capital gains if they can offset some gains with losses and then only distribute the gains that are left. So that’s a way that they can be more tax efficient than the market itself.

There are some advantages to passive investing. Some of those are lower fees. Fees are like an expense ratio, a management fee that you’re going to pay for a fund or an ETF to manage your money or manager, in general, in an SMA or a separately managed account. But because there’s no one picking stocks, oversight is much less expensive when it comes to passive. So passive funds really are following the index and therefore, have lower fees.

Another one is transparency, where you can generally see always what is in a passive fund. Especially in ETF, you can see it in real time, even during the day. But even with a mutual fund, you can see it-

Josh Robb:

Or have a reasonable expectation of what’s…

Austin Wilson:

… it’s going to be very similar to the market, and you can usually find what’s in the market. So therefore, very transparent and they are somewhat tax efficient in their own rights because it’s a buy and hold strategy, so you typically don’t get massive capital gains distributions for a given year when you hold a passive investment. So those are some pros to both kinds.

Now, there are also, obviously, disadvantages. So active management, one of the biggest disadvantages is it’s more expensive. Like I mentioned, with passive being a lower fee, well, there’s more fees associated with active management. Really, if you look at some comparisons, the average expense ratio for an active manager is about 0.68% per year.

Josh Robb:

These are for mutual funds and ETFs.

Austin Wilson:

These are for mutual funds, yup, or ETFs. And for a passive, it’s only 0.06% per year. So that’s a big difference. But you’re paying for our research team, you’re paying for expensive portfolio managers, and all of these things there.

And the other disadvantage of active is active risk. You’re not holding the market, so you’re going to be taking different bets pro for or against certain companies and those are going to generate different returns in the market. Your hope is that they’re going to bring high returns, but they also can bring bad returns if it goes the wrong way and you have an outsized position compared to the market. So that’s called active risk. It’s risk from taking an active position or a larger or smaller position than the market there. So those are some disadvantages of active.

There are disadvantages to passive too. It’s very limited. There are not a ton of options in the passive world, so you’re really limited to a specific index or a predetermined set of investments with little to no variance between them. There’s like 100 probably S&P 500 index funds.

Josh Robb:

But they all look the same.

Austin Wilson:

It’s an S&P 500 index fund, and you’re locked into those holdings. No matter what happens in the market, no one’s trying to take risk off the table when things get too good or bad or whatever like that. If you think about returns over time, if your goal is to have market returns, you’re going to get market returns.

Josh Robb:

Or slightly less with the expense ratio.

Austin Wilson:

With the expense ratio. Slightly. But you’re never going to outperform the market. You’re going to get at best market returns, and if you believe that managers can outperform the market, you’re never going to be able to do that with a passive investment. So you’re limiting yourself there with less risk, of course. So those are some disadvantages of passive.

 

[14:25] – Frequently Asked Questions on Active Vs. Passive Investing

Austin Wilson:

Now, let’s look at some like FAQs, frequently asked questions, about active versus passive. So you may ask how much of the market is passively invested?

Josh Robb:

Hey, Austin.

Austin Wilson:

Yeah?

Josh Robb:

How much of the market is passively invested?

Austin Wilson:

Oh man. So according to industry research, around 17% of the stock market in the US is passively invested. Now, this should actually overtake active trading by around 2026.

Josh Robb:

Oh, wow.

Austin Wilson:

Yeah. But in terms of mutual fund money, so looking just at mutual funds, around 54% of US mutual funds and ETFs are in passive index strategies as of 2021. Passive funds overtook active funds in the mutual fund ETF space in 2018. So it hasn’t been in that way that long.

You may also ask…

Josh Robb:

Are all ETFs passive, Austin?

Austin Wilson:

Well, that’s a great question. They’re not. In fact, a lot of ETFs are passive. So you can buy a lot of S&P 500, Russell 1000, bond market ETFs that are literally passive indexing options. However, many ETFs are more actively managed, follow different strategies, and those are becoming more popular as time goes on as well.

And Josh, one final question.

Josh Robb:

Yes. When was the first passive index fund created?

Austin Wilson:

It was actually the Vanguard’s 500 Index Fund. I guess you would want to know what that’s tracking. Probably the S&P 500.

Josh Robb:

Right. Makes sense.

Austin Wilson:

That was launched by John Bogle, the index fund pioneer in 1976.

Josh Robb:

Wow.

 

[15:56] – Austin’s Opinion on Active Vs. Passive

Austin Wilson:

Yes, 1976. So those are some pros and cons, some FAQs on active versus passive, and now, the moment you’ve all been waiting for: my opinion on active versus passive, Josh’s opinion on active versus passive, and I’ll go first. So I believe that the market is efficient in the long run, long run. So corporate earnings drive stock prices higher over time. That’s kind of something that’s pretty basic. So I think in the long run, that does make a lot of sense, generally efficient over the long-term. But I believe in the short-term, and I’ve seen this in our own experience that there are inefficiencies in the short-term.

I think that there are opportunities to take advantage of depressed stock prices that are much more depressed than fundamentals would say or over inflated stock prices that are over-exuberant based on what the fundamentals would say. So I think over the long run, stock prices are going to follow corporate earnings. I think in the short run, inefficiencies to take advantage of as active managers. I do believe that small caps, international stocks and emerging market stocks and bond markets are far less efficient than the US large cap stocks.

Josh Robb:

And is it something like 80% of active bond managers outperform because of their ability in that state to be-

Austin Wilson:

Right and stocks is much less. Stocks is much less. I think that it’s a much less efficient market in small cap international EM and bond market investment opportunities. So, there are greater opportunities for significant and sustained outperformance in those areas of the market.

I also understand that active managers will underperform the market occasionally, even some people do it more often than not because active management’s very, very difficult, which is one of the reasons people like passive management because they don’t believe people can time that or do things that well over time. But it is very hard. But I recognize that active managers often underperform the market, but the goal is to outperform more than you underperform.

I believe that most investors, this is my opinion, would be suited hiring an active manager over the long-term, but that long time horizon is key. If you have a very short time horizon, it’s very hard to judge an active manager on how they’re performing versus a benchmark because they’re going to be out of favor at some point. They’re going to be in favor at some point, hopefully, as well.

I do think that passive can be useful for people starting out because they have really low fees. So that’s good, and it’s very, very simple. You’re buying the market. You’re creating those habits early on. I think that’s super important, and admittedly, I definitely favor active investing, but I wholeheartedly believe that passive is way better for people than not investing at all. Don’t take that as if you only have passive options, like it’s bad. No, that’s better than not investing, for sure. That’s a good thing. You’re investing. You’re going to get market returns. That’s a great step in the right direction.

So those are my opinions. Josh, what are yours?

 

[18:46] – Josh’s Opinion on Active Vs. Passive

Josh Robb:

All right. So, I am looking at this from a financial advisor perspective. So, my answer is it depends. Look at that. Wow.

Austin Wilson:

Oh man. Shocker.

Josh Robb:

But really, I am at a firm, and we do active management in that we build custom portfolios for our clients. We use some active management. We have some passive or more beta-driven investment choices where it’s a little less volatile.

We also, for our clients, recommend or give allocations for their retirement plans at work, which historically have passive investments in 401(k) plans or retirement plans. And so, depending on the situation, the objectives, and their choices, there’s really, it’s active or passive. And from an advisor standpoint, I’m actually indifferent. It comes to risk tolerance, comes to goals, objectives, timeframe. Like you said, horizon, time horizon matters. But in general, picking a strategy and sticking with it is huge, right?

Austin Wilson:

Yeah, absolutely.

Josh Robb:

Coming and jumping back and forth, saying, “Well, I see this guy’s doing really well. I’m going to invest in him. Oh, he’s not doing well. I’m leaving.” That actually, in the long run, really hurts you. You find something like. You stick with it. I’ve seen success with active management and to me, active management, we talked about funds and how they approach it. An active management could be simply a person with their 401(k) adjusting their allocation periodically. You become the active manager.

Austin Wilson:

Yeah, absolutely.

Josh Robb:

Using passive investments, saying, “Oh, you know what? I want more on this fund now because I think it’s going to do well” or whatever. You’re now the active manager and you’re using passive investments to do that. So, I think more and more people are active than they actually let on because they’re tweaking their portfolio periodically, even though they’re using passive investments.

Austin Wilson:

Right.

Josh Robb:

And so I’m a fan of active management in that when you have a plan and a strategy, you need to adjust it over time. You’re not making big adjustments and you’re not running in fear, but there’s opportunities or there’s just situations where you say, “You know what? Right now, I’m going to hold more cash because I’m a year out from retirement and I need to start building up kind of a starting point to transition,” right?

Austin Wilson:

Right.

Josh Robb:

That’s taking an active management approach because you’re adjusting your allocation outside of just holding whatever. When I think of active management, for me, active management is really making adjustments to your overall allocation in your portfolio to meet your objectives. What you hold in there could be an active fund, could be a passive fund, could be individual stocks, could be individual bonds. It doesn’t matter. I think there’s more active involvement for most people than they let on.

I’ve run into people in my course of business where they’re huge on looking at those expense and buying the cheapest fund. That’s great. And you’re going to get, if you’re buying that passive fund, you’re going to get the results or very close to that benchmark and then, they’re making adjustments along the way and I said, “Well, you’re active.” And they’re like, “No, everything I hold is an index fund.” Yes, but you’re changing things along the way. That’s active.

So I think active is more, in my mind, the approach to where you end up or how you get there. I’m less concerned about which one you use, what makes sense. I think you find good active managers, they will outperform in the long run. There’s a recency bias in that those that survive, drive or change the results on success, right?

Austin Wilson:

Right, right.

Josh Robb:

Because if you only look at what’s left, they’re probably pretty good ones because they’re the ones that stuck around. But you find good managers that have a good process that you believe in.

Austin Wilson:

That’s the key.

Josh Robb:

That’s the key. But I have seen efficiencies in the market. Like you said, there’s places where, either due the size or due to nuances, it is hard for the average to maintain kind of that performance that a good manager who can then pick and choose can now perform pretty easily.

Austin Wilson:

Right.

Josh Robb:

So all that to say whether or not you use certain funds that are active or passive, your approach to building and heading towards your end goals probably means at some point in time, you are actively adjusting to get back on course, to adjust for changes in your plan, those type of things. But in general, I really don’t care, from an advisor standpoint, what you use as long as you believe in what it is and you’re going to stick with it.

Austin Wilson:

Absolutely. That is a great wrap up and thank you for being here, listening this week. Hopefully, you learned something. If you had someone asking about active versus passive in your world, feel free to send them this episode. Share it with friends and family. Again, we’d also love it if you’d subscribe and leave us a review on Apple Podcasts or Spotify.

So until next Thursday, have a great week.

Josh Robb:

All right. Talk to you later.

Austin Wilson:

All right.

Thank you for listening to The Invested Dads Podcast. This episode has ended, but your journey towards a better financial future doesn’t have to. Head over to theinvesteddads.com to access all the links and resources mentioned in today’s show. If you enjoyed this episode and we had a positive impact on your life, leave us a review. Click Subscribe and don’t miss the next episode.

Josh Robb and Austin Wilson Work for Hixon Zuercher Capital Management. All opinions expressed by Josh, Austin, or any podcast guest are solely their own opinions and do not reflect the opinions of Hixon Zuercher Capital Management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Hixon Zuercher Capital Management may maintain positions in the securities discussed in this podcast. There is no guarantee that the statements, opinions, or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principle. There is no assurance that any investment plan or strategy will be successful.