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Choose Passive Over Active Stock Fund Management? It Depends

By , with Annuity FYI

Debates have raged for decades about the relative advantages and disadvantages of active stock fund investing versus passive investing. While interesting, however, it has always been relatively inconclusive. 

That is, until now, at least in the eyes of the majority of investors.

You need look no further than the turf battles between The Vanguard Group and Fidelity Investments, the two biggest investment giants catering to the public. For years, Fidelity, the biggest actively managed mutual fund company, raked in more money. More recently, Vanguard, the biggest passively managed mutual fund company, is the kingpin. And, pressured by changing investor preferences, Fidelity has also become a big player in passive funds, as well as its mainstay active funds. In fact, Fidelity 500 Index Fund has become the biggest Fidelity mutual fund of all and the second-biggest mutual fund on the market, with $274 billion in assets.

Nevertheless, it’s still dwarfed – as are all mutual funds – by No. 1 Vanguard Total Stock Market Index Fund (Admiral Shares), which has $921 billion in assets. And the third biggest fund is also passive – Vanguard Institutional Index Mutual Fund, with $232 billion in assets. By comparison, the biggest actively managed fund – The Growth Fund of America – has only $139 billion in assets.

Why such heightened interest in passive funds? It’s because investors have mostly enjoyed a bull market for more than a decade, which makes it easier for all types of funds to fare just fine. This makes it harder for active funds to outperform, and it doesn’t help that passive fund investment fees are materially lower. 

The Covid-19 pandemic put a temporary dent in the explosive passive investing trend. In March 2020, as markets plunged, the case for actively managed investments grew stronger as those funds performed better than passively managed funds. Both active and passive strategies suffered steep drops from the end of February to the end of March, but passively managed funds suffered more.

But this situation didn’t last for long. The heightened popularity of passive investing versus active investing resumed only a few months after the market started rebounding in late March 2020. Investors once again began to prefer passive funds and still do. 

Yet this doesn’t mean you should shift from actively managed mutual funds to passively managed funds if that is where some of your investment funds reside. In fact, both approaches are valid, fundamentally boiling down to a matter of investment philosophy. . 

What counts much more is the discipline of long-term investing and the realization that past performance is not indicative of future results. Passive funds have advantages, but so, too, do active funds. Each offers advantages. Passive funds offer lower costs, more tax efficiency and the unbridled embrace of market efficiency. Active management offers the potential – albeit certainly not a guarantee – for above-market returns.

In viewing the pros and cons of passive versus active investing, market efficiency – the degree to which stock prices reflect all available information – always enters a worthwhile discussion. In a perfectly efficient market, all stocks are precisely valued and no active manager can outperform the market. If the market was perfectly efficient, there would be no demand for active investing. But it isn’t perfectly efficient. So some active fund managers can and do beat the market, in some instances more than others. 

Based on extensive research by investment firm Baird, one key conclusion boils down to this: You’ll probably do better with a passively managed core big cap stock fund and better with an actively managed small cap value fund.

The median large-cap core fund outperformed its benchmark only 20 percent of the time in various one-, three- and five-year periods. By contrast, the median small value fund beat its benchmark 67 percent of the time in these periods. So in the latter arena, you’re obviously better off with a good actively managed fund.

Baird also notes that investors may fare better in even actively managed diversified big cap funds if they are top-quartile performers. Their performance is materially superior. This decision is a closer call, however. The reason is that it’s tough for a manager to maintain this ranking over time, although some Fidelity funds and others have managed to do so.

To reiterate the basic points, most folks are probably better off investing in a passive fund if they want to buy big cap stocks and generally better off in an active fund if they want to buy small cap stocks. They may also be better off investing in an active fund focused on big cap stocks if it’s deemed a top-tier fund, but this can backfire.

Most important is investing in the fund you like — positive or active – regardless of the reasons. If you invest for the long haul, as you should, your success is based overwhelmingly on the performance of the stock market. This dwarfs everything else.

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