Questions from a Reader: What is the Best Way to Invest? by Phil Bollin - Bollin Wealth Management

Frequent Toledo Business Review reader John M. of Holland recently emailed me suggesting an article discussing the merits of passively managed mutual funds vs. actively managed funds. John is 25 years old, just beginning with investing and has been reading a lot about the two investment approaches. Before we begin our discussion, I will preface this article by stating that our firm is in the minority of advisory firms that advocates passive investing strategies. Our discussion will also be very cursory, as a comprehensive examination of these two types of fund strategies could easily span a three hundred page book!

Perhaps it’s best to start with simple definitions for active and passive investing. Passive investing strategies are designed to match broad market returns. For example, a passively managed large cap mutual fund’s goal would be to match the returns of the S&P 500 index, which comprises the 500 largest stocks in the U.S. stock market. Active investing strategies are designed to beat market returns by attempting to time the market correctly and/or selecting securities that will outperform the market. An actively managed large cap mutual fund’s goal is to beat the S&P 500 index.

There are some fundamental differences between active and passive mutual fund investing. One of the most significant differences is the cost of the two types of funds. Actively managed mutual funds have expense ratios three to four times higher than passively managed funds. And that is not even considering sales loads associated with many actively managed funds or trading expenses, which are not reported in a prospectuses’ expense ratio. Another major difference between the two types of funds is turnover, or how often the fund’s investments are bought and sold. Most actively managed funds have turnover ratios around 100%, meaning the fund has changed its entire portfolio from January 1st to December 31st. In stark contrast, passively managed funds experience a fraction of the turnover, resulting in lower transaction costs and more favorable tax treatment. Another fundamental difference is human error. Actively managed funds are exposed to human error every time a stock and/or bond is bought and sold. Passively managed funds, in contrast, eliminate human error because they have rigid rules concerning when stocks and/or bonds are bought and sold.

Actively managed mutual funds have had greater acceptance among investors for decades, but passively managed funds have been gaining in popularity in recent years. One of the reasons that passive investing strategies have increased in popularity is a 1992 study by Gary Brinson that ascertained the determinants of an investment portfolio’s performance. What Brinson discovered was asset allocation was responsible for 93.6% of investment performance, while security selection and marketing timing were responsible for 2.5% and 1.7% respectively. Brinson’s findings seemingly refute the widely-held belief that fund managers can add significant value for investors by trying to time the market or pick stocks in their portfolio. Investors need to ask themselves whether the miniscule impact of security selection and market timing on a funds performance is worth the much higher expenses of actively managed mutual funds.

We can also take a look at actively managed mutual funds from a more logical viewpoint. Let’s say we want to construct a diversified portfolio of 10 funds representing 10 different asset classes (the importance of diversification is a topic for another article). We’ll momentarily ignore the fact that for every asset class there will be a sizeable percentage of funds that actually achieve market returns. For our example, we’ll assume that for every fund that beats the market return, there will be one that fails to achieve market returns. Therefore, 50% of our funds will beat the market, and 50% will fail to make market returns. What is the likelihood that we can construct a portfolio of 10 mutual funds that will beat the market for each respective asset class?

Multiplying the probabilities together, we get (.50)10, which yields a result of .0009765625, or .0977%. This means that we have a less than one-tenth of 1% chance of successfully selecting 10 actively managed funds that will beat their respective market benchmarks. If you ask me, those aren’t very good odds, and those results were calculated using very favorable and unrealistic numbers. As an investor, I’d much rather have 100% chance of getting market returns with passively managed funds than have a one-tenth of 1% chance of beating the market with my portfolio.

I have mathematically shown, at least in theory, that it is very difficult to beat the market on consistent basis. There are examples of actively managed funds, however, that have been able to do it with regularity.

So which approach is better for you, passively managed or actively managed funds? There is no right or wrong answer, as it is largely a matter of what you believe and your personal preference. Hopefully you have been exposed to a viewpoint that challenges widely held industry assumptions and are better able to make investment decisions for yourself.