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Active versus passive investing: Yahoo U

·3 min read

For more business and finance explainers, check out our Yahoo U page.

Among the many debates in investing: whether or not active investing is an efficient way of beating the market.

On one hand, the growing popularity of retail trading platforms like Robinhood have fueled interest in stock picking. But on the other hand, exchange-traded funds (ETFs) have made it easier for investors to passively purchase baskets of stocks.

So which one works better?

First: the difference between active and passive.

What is active investing?

Active investing is a strategy that involves crafting a portfolio of securities and “actively” managing that portfolio to make profits.

Active investing can be done by the investor themselves or via wealth managers and investment firms.

The biggest upside from active investing is the chance at outperforming the market, which of course means there’s also the downside risk of underperforming the market.

What is passive investing?

Passive investing is the opposite strategy: buying a slice of the whole market and holding it.

Exchange-traded funds are a common way to do passive investing. ETFs are put together by a provider that owns the underlying stocks to build and “mirror” an index (like the S&P 500) or a sector (like emerging markets).

The provider then offers it on a stock exchange for people to buy and sell just like any other stock.

Passive investing is a generally cheaper strategy than active investing. Because ETFs require little maintenance, the firms that put them together often charge low fees compared to active managers, who ask for a larger cut.

What’s performed better as of late?

The idea behind active investing is the hope that the portfolio manager can beat the market.

For 2020, data from Morningstar shows that a majority of active funds targeting U.S. stocks did not. Only 42% of active funds outperformed the average of their passive competition. Those particularly focused on U.S. large-cap stocks, covering the hottest names on the market, were even less likely to outperform, with only 38% of active funds outperforming.

Instead, active investing appeared to see better results in non-U.S. equities sectors like intermediate core bonds, high-yield bonds, and diversified emerging markets.

In 2020, 71% of active funds focused on U.S. real estate outperformed passive funds.

How about over the longer-term?

The aforementioned data covers one-year performances. But the same Morningstar data shows that over a longer-time horizon, active funds across the board are very unlikely to beat the market.

For U.S. large blend active funds, only 8.1% of funds were able to beat their passive competitors over a 10-year period. For mid-cap and small-cap funds, the outperformance rates are slightly better, at 11.9% and 19.9%, respectively.

What’s more popular - active or passive?

Bank of America Securities noted that as of November 2020, the share of passively managed assets under management (AUM) for U.S. stocks was 47.5%, so not yet a majority. But that figure has been steadily rising over the past 15 years, with money flowing out of active funds and into passive funds.

A report from Bank of America Securities highlights the 15-year trend of rising popularity in passive funds.
A report from Bank of America Securities highlights the 15-year trend of rising popularity in passive funds.

“The share of passively managed AUM has stabilized for equity funds and ETFs this year, although active funds continued to report net outflows,” BofA Securities said.

But the shift from active to passive trend hasn’t always been the case; active funds were more popular than passive funds through the 1980s and 1990s.

There may be large macroeconomic reasons for the switch, with the last 15 years distinctively defined by low inflation and low interest rates.

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