So, while passive versus active investing is often presented as a simple either/or, there should never be a binary choice between active or passive investment vehicles as the sole solution to your investment needs. This said, it's important to understand the arguments surrounding passive versus active investing and why, despite the growing popularity of passive products, there should be room for active investments in your portfolio:
Performance. Passive providers often bandy around the statistic of how more than 50 percent of active managers underperform the benchmark. However, they never quote their own result against the same measure, because 100 percent of passive products underperform the same benchmark by at least their cost. So some active managers underperform, but all passive managers do.
The counter-argument is that at least the size of passive managers’ underperformance is known upfront, whereas the variability of the active managers’ performance is not known. At the same time, it’s important to remember that active managers outperform as well.
Furthermore, these statistics demonstrate survivorship bias in that while poor managers usually end up closing shop, their poor numbers usually remain in studies - even though they are no longer available as investments.
A more appropriate analysis would be to examine the percentage of active managers who are open for investment today that outperform passive products on an after-cost basis.
Costs. Passive product providers often compound their theoretical cost-savings over long periods of time and highlight the amount in absolute terms. And indeed, the cost characteristics of passive products are highly attractive, and should be used in asset classes where it’s possible to sensibly apply them, like in core holdings of equities.
It doesn't, however, make sense to use passive products in asset classes such as fixed income, foreign exchange and physical commodities, where an active product is far superior.
Additionally, the longer the investment horizon, the more likely that an active manager would outperform their passive peer, so making a blanket “saving” assumption could be very costly indeed.
Investment wisdom. Passive investing discards all investment wisdom obtained throughout the last century, all for a single standard: it’s cheaper. And while cost is, of course, an important factor, using costs as your first or only investment criterion inevitably leads to poor decision-making.
Here is some common investment wisdom, and how passive investing ignores this wisdom entirely:
Rule number one - don’t lose money. Passive solutions are ambivalent to market direction.
“This time is different.” These are perhaps the four most dangerous words in investing, which passive solutions disregard by buying most of whatever is currently in favour.
The importance of valuations. Passive solutions acknowledge only price and disregard valuation.
George Herman is a director and chief investment officer of Citadel.