In the wake of Eugene F. Fama, Robert J. Shiller and Lars Peter Hansen sharing the 2013 Nobel Memorial Prize in Economic Sciences for their work on the pricing of financial assets, I thought it was a good time to post on passive versus active investing. An active investor is looking to add value to his or her portfolio by capturing excess return, or beating the market. A passive investor isn't trying to capture excess return. Investors buying and holding a market index aren't trying to beat the market, but be the market.
The market will, of course, earn its return. Index investors can capture the market return, less any portfolio management or administration fees, by investing in a mutual fund or an exchange-traded fund, or ETF, based on the market index. One problem investors face is which index to choose when they invest in a market index. The Standard & Poor's 500 index, for example, is based on 500 large capitalization, or large-cap, stocks. A stock's market capitalization often is based on the number of shares freely available to trade (free float) times the market price of the stock.
Pick that index, however, and you're not capturing the return on small- or mid-cap stocks. Some investment professionals say that cap-weighted indexes aren't appropriate because your investment is concentrated in the stocks with the highest stock prices and most number of shares. You're buying the current market darlings and hoping that they will continue to go higher. Alternate approaches to index weights are equally weighted, fundamentally weighted and value-weighted indexes. Investors that aren't happy with a cap-weighted approach can look to these alternate index weightings to find one more attuned to their investment philosophy.
Getting more exposure
Of course there's a lot more to investing than just U.S. stocks. There are foreign stocks in developed and emerging market economies, domestic and foreign bonds, real estate and alternative asset classes such as precious metals and commodities. Limit yourself to a U.S.-centric portfolio, and you can miss out on the benefits of international diversification. Limit yourself to stocks, bonds and cash (shorthand for short-term debt), and you don't gain exposure to the other asset classes.
Indexes are available in global bond and equity securities, too. There's not one right mix for everyone, so investors have to find the mix that's right for them based on their investment goals and their attitude toward risk in investing.
An actively managed investment portfolio has to earn more net of fees than the index portfolio's return net of fees for the investor to be ahead. That's a difficult standard to consistently meet over time. Benchmarking an actively managed portfolio is also a bit more complicated than just comparing the net return to the net return on an index.
One thing that active investors want to avoid is portfolio managers that invest too closely to the index. Called closet indexing, the investor is paying for active management but getting results that are very similar to passive management.
One approach I think is attractive is called core-satellite investing, where the investor's core portfolio is invested passively in index funds with low management and administrative fees, and the balance of the portfolio is actively managed. By separating the two, the investor is only paying active management fees on the part of the portfolio that is actively managed.