The Active Vs. Passive Management Debate

Will there ever be a definitive answer to the active vs. passive management debate? Likely not and here are possible reasons why we will never have a complete answer to which method is superior. At the very core of the argument is lack of data, at least as it pertains to one level of the argument.

The active vs. passive argument is carried on at two levels. One level is "individual" based while the second level focuses on broad averages. Let's first concentrate on the broad average side of the argument as here we have plenty of data and it tilts the argument toward passive investing as the superior approach. Active mutual fund manager performance is "research ready" and study after study shows that over time, a high percentage of active mutual fund managers fail to beat their benchmark. Check out Richard A. Ferri's book, The Power of Passive Investing: More Wealth With Less Work and writings by William J. Bernstein, David Swensen, Larry Swedroe, Charles Ellis, Burton G. Malkiel and others. Where the data is available, as it is for thousands of professional money managers, the odds of outperforming the broad market are low. Active management is a losers game when based on large numbers of investors.

When the argument comes down to individual investors, the conclusions are not as clear cut. Lack of data is a major problem. Research of how well thousands of small individual investors perform is nil - and for good reason. Who wants some researcher pawing around inside their portfolio only to expose poor performance. As I watch the active-passive debate on the Internet, those in favor of active management are arguing at the individual level while those favoring passive investing are basing their reasoning on results of broad average analysis. David Swensen puts it very well in his Unconventional Success book where he writes the following. "Thousands upon thousands of professionally managed funds routinely fall short of producing even market-matching results. If highly compensated, specially trained, handsomely supported investment professionals fail, what leads part-time, financially untutored, resource-deficient individuals to believe they can succeed?" There are just enough outliers working the system and well financed advertising budgets to seduce a significant percentage of individuals into thinking they are "Lake Wobegon" investors. In other words, they are above average. Simply put, the majority of these investors suffer from the Dunning-Kruger Effect.

Probability arguments will concede that there are, and will continue to be, active managers who outperform the board market. That is a given and because this is the case, we see this side or level of the argument stated any time the active vs. passive issue arises. The question for the individual taking this side of the argument, which goes against the laws of probability, is simple. How do I prove I am better off as an active manager?

My suggestion is as follows. Since the individual may be a super active manager, attempt to answer the question at the individual level by setting up two portfolios. One is based on the best passive management principles and the second portfolio is actively managed. Monitor both portfolios carefully over as long a period of time as possible. Fifteen to twenty years seems to be reasonable. One should begin to pick up clues after five to ten years of investing.

For active management advocates, here are a few questions to answer.

Most investors who claim to outperform the market have not been selecting stocks for 40 or 50 years. And for those who have, there remains a few more challenging questions to answer.

1. What software is used to track portfolio performance and does it accurately handle cash flowing in and out of the portfolio?

2. What benchmark is used to judge portfolio performance? Is the benchmark appropriate for the portfolio? Has the benchmark been customized for the portfolio? Look up Benchmarking on this blog, ITA Wealth Management.

3. What risk measuring tool is used to determine the volatility of the portfolio? Examples of risk measurement tools can be found within the TLH Spreadsheet in the form of the Sortino »">Sortino and Retirement Ratio.

If one is able to provide reasonable answers to these three questions and still perform better than their benchmark, keep at it. We recognize there will be successful investors during different time frames. When argued using large averages, passive management wins the day. However, active management does have its victors when argued on the individual level as there will always be outliers to the larger body of investors. How are you going to play the probability game?