A little low-stakes gambling for entertainment is one thing, but gambling with money saved for retirement or educating children is quite another. Yet that is basically what investors are doing when they invest through active investment managers–those who buy and sell stocks within stock or bond mutual funds or within the separately managed accounts, attempting to beat the markets.
Passive management is a far superior alternative because it doesn't rely on the speculation of investment managers. Passive strategies include funds that reflect a particular asset class (for example, small cap stocks, large cap stocks, value stocks) or those pegged to a generic index such as the S&P 500. The returns of those investments aren't contingent on the judgment of investment managers. Instead, they reflect prices, in the aggregate, of the securities in the asset class or index being used. Investment vehicles commonly used for passive management strategies include institutional asset class funds, generic index funds, and exchange-traded funds, or ETFs.
Just as it's impossible to predict which slot machines will pay off, there's no way to know in advance, which investment managers will deliver or when up periods will occur. Owning a diversified portfolio of asset-class funds or index funds, by contrast, is more like owning the casino. Just as casinos make money on aggregate losses, investors in index and asset-class funds can profit from aggregate market returns. A significant factor affecting the potential returns and advantage of passively managed investments and those of actively managed funds is costs–expenses and fees. For index funds, costs on average are often one-fifth of those of actively managed funds, which often charge expenses and fees totaling 2 percent to 3 percent a year.
Extensive academic research supports the case for choosing passively managed funds over actively managed funds. In his classic article "The Arithmetic of Active Management," renowned finance researcher and economics Nobel laureate William Sharpe concludes that, because of expenses and fees, the average investor in actively managed funds ends up underperforming the average returns of a given index. (However, index funds don't assure lower costs. Some, offered by large financial services companies, carry high costs. As always, consumers should obtain and review funds' literature carefully before investing.) Costs aside, investors buying actively managed funds have the impossible challenge of choosing winning fund managers. Jason Zweig, a widely known financial author, says the odds of investors “selecting the top funds are as good (as those) that Big Foot and the Abominable Snowman will show up in pink ballet slippers at your next cocktail party.”
Also supporting the case for passive management is the efficient-market hypothesis. It holds that stock picking, even by professionals, is futile because all public information about a security is already reflected into its price. Prices move in response to unexpected information. Because of this, the short-term movements of stock prices are random, and thus unpredictable.
At workshops, I give every person a quarter, have them stand, and ask them to flip it. Then I ask those for whom the coin comes up heads to remain standing. We keep flipping. Sometimes there’s a guy who's still standing after six flips. I ask the crowd: Could you have identified in advance, which person would get heads six times in a row?
So it goes with active managers. One of the most successful actively managed funds ever–for a time–was Legg Mason Value Trust, managed by Bill Miller. His stewardship delivered substantial returns from 1991 to 2005. But between 2006 and 2008 he did so badly that he nearly wiped out gains from the preceding 15 years of attention-getting performance. Investors who didn't get into the fund until after 1993 and stayed in until 2008, were surely disappointed. Miller was still standing after many successful coin flips, but from 2006 to 2008, his coin came up on the wrong side.
Then why is active management so popular? Because those funds, a Wall Street-centered industry, are sold aggressively by people collecting substantial fees and commissions. Ironically, one of the strongest endorsements of passive management comes from the investor best known for success in active management: Warren Buffett. In the 1996 annual report of his firm, Berkshire Hathaway, Buffett states: "Seriously, costs matter. Most investors, both institutional and individual, will find that the best way to own common stocks is through index funds that charge minimal fees. Those following this path are sure to beat the results (after fees and expenses) delivered by the great majority of investment professionals."
The choice between active and passive management comes down to this: Do you want to gamble in a casino or own it?