The Active Versus Passive Debate is Not Binary

By John Reese (@guruinvestor) — 

There is an undercurrent running throughout the investment community suggesting that active stock-picking is the root of many investor ills, and one that has robbed them of returns. I would argue, however, that the debate is more gray than black and white.

Passive investing, an approach in which investors buy a broad cross-section of the market and weight holdings based on market capitalization, is a rules-based, disciplined strategy that strives to obtain the same return as the broader market. Active investing, also referred to as “stock-picking” involves the individual selection of securities by an investor or portfolio manager. The shift away from active and into passive has been dramatic, driven by both the lower cost and historically better performance of passive funds. According to Morningstar, passive funds attracted inflows of $428.7 billion over 2016, while actively managed funds saw outflows of $285.2 billion, a trend that has occurred for nearly 10 years. Still, the lion’s share of invested dollars is actively managed (upwards of $10 trillion), and there is heated debate around whether or not the cost-benefit arguments against active investing are well-founded.

A recent Bloomberg article outlines a debate between columnists Barry Ritoltz and Nir Kaissar on the subject of passive versus active investing. Ritholtz argues that investors should have a “big chunk” of their portfolios passively invested based on the following factors:

  • Lower costs;
  • Better performance;
  • Avoiding “closet” indexers that charge high fees;
  • Insulating themselves from harmful decision-making

Kaissar, however, refutes, “I’m not ready to concede that lower cost and better performance are on the side of passive investing,” adding that those active management styles based on value, quality and momentum “have historically beaten the broader market. The problem is that active managers kept the profits for themselves by charging investors absurdly higher fees.” On the whole, however, Kaissar agrees that “expensive and underperforming active gives the entire complex a bad name.”

There are shades of gray in both the active and passive investment camps. Each approach presents a continuum of strategies available to investors that can be used in a wide range of combinations. Clearly, if an active approach involves buying a stock because it’s performing well at the moment or is the subject of exciting media buzz–this can be a risky proposition, but there are other types of stock picking that can be less risky. Choosing stocks based on proven strategies and underlying fundamentals, for example, can increase an investor’s odds of enjoying outperformance over time.

At Validea, we use an investment approach that draws from both active and passive strategies through stock screening models we constructed based on the philosophies of investing greats Benjamin Graham and Warren Buffett, among others. Both Graham and his protégé Buffett, while considered active investors, applied an extremely conservative and disciplined approach to analyzing and buying stocks. Graham, who earned the nickname “The Father of Value Investing”, made the case for a version of active investing that combines both discipline and sound investment decision-making based on analysis of concrete fundamentals. In the preface for the fourth edition of Graham’s book The Intelligent Investor, Buffett praised it as the “best book about investing ever written” and wrote:

To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework. This book precisely and clearly prescribes the proper framework. You must supply the emotional discipline.

The investment approach we use at Validea incorporates aspects of both active and passive investing, as outlined below:

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Most of our models examine a series of different variables when analyzing a stock, looking for those with the most combined interest from our different strategies. By using this type of blended approach, investors can smooth out downside volatility and guard against the urge to react emotionally when the market inevitability takes a turn.

A Barron’s article from 2015 offers perspective vis a vis the ubiquitous active versus passive debate: “In truth,” it says, “while the polarized positions speak to different groups of managers battling for fund flows and for the upper hand in a market debate, most investors are best served not by an either-or approach.”

Photo: Copyright: Rabia Elif Aksoy / 123RF Stock Photo

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John Reese is founder and CEO of Validea.com and Validea Capital Management, LLC. Validea is a quantitative investment research firm and Validea Capital, a separate company from Validea.com, which maintains this blog, is a asset management firm offering private account management, ETFs and a robo advisor, Validea Legends and Validea Legends Income. John is a graduate of MIT and Harvard Business school, holder of two US patents and author of the book, “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Follow John on Twitter @guruinvestor