Passive Investing vs. Active Investing

A popular debate investors like to squabble over is whether to invest passively into Index Funds or to utilize investment managers who take a more active approach to money management. There are going to be a few key differences between the two. First and foremost the index funds, like their name suggests, simply track an index (i.e. the S&P 500, or Russell 2000). Often times these funds utilize software devices to do the tracking for them. Active managers on the other hand will pick and choose stocks on their own requiring much more time and effort on their part. Due to the extra work required of active managers higher expense ratios can be expected. With these higher expenses come a required higher rate of return just to break even with their rival index. So the big question you have to ask yourself is not whether a manager can match his or her benchmark, but rather can he beat the benchmark by a greater amount than the expenses. Investment managers will often tell you yes they can because they got experience, and a piece of paper that says "CFA" (which merely means they read a lot theories and passed a couple tests) Now I'm not docking the CFA, it is an extremely hard test and requires a lot of work and knowledge, but a recent look at history will tell us that the certification doesn't equate to a crystal ball.

Take a look below at the stats from Morningstar to judge for yourself whether or not managers hit their mark in the past 12 months.

• Only 26% of large cap managers beat their benchmark
• 37% of mid cap funds beat their benchmark
• A measly 20% of small cap funds beat their's
• Worst of all only 17% of bond managers was higher than the benchmark
• Of the 18 sub-categories in this research only 3 categories outperformed

What does this mean? It means that a lazy investor could beat over 75% of professionals by simply choosing to go with index funds. How is this possible? It is possible because most actively managed funds over charge their customers in fees and commissions. Now am I suggesting to never go with an actively managed fund? Hell no...some fund managers are real professionals and are reasonable with their expenses. For example, Donald Yacktman of the Yacktman fund in the last 3 years have returned his clients nearly 23% compared to the S&P 500's 8%. Yacktman has outperformed the index nearly every single year and charges less than 1% to investors.

If you are going to choose an actively managed fund you have to do your homework. There are a few all-stars here and there that consistently beat the market, but remember historical performance is not always an indicator of future outcomes.

Next week I'll share with you how a lazy man can not only diversify risk, but outperform the market. Remember it is better to think smarter than to work harder.