“We’ve long felt that the only value of stock forecasters is to make fortune tellers look good.” This classic quote from Warren Buffett encapsulates the guiding principle of passive investors, who prosper not by trying to do better than the stock market, but by mimicking it at a low cost. These investors are often proponents of index funds and ETFs, which are “portfolios that match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500).”1
Active investors are those who try to beat the performance of the overall stock market by selecting stocks (or other investments, such as bonds, real estate or precious metals) whose value will grow faster than the market as a whole. Do they succeed? Yes-a few of them do, sometimes. The catch is that there is no single manager or group of active managers that consistently outperform year in and year out. A few managers may have a strong, multi-year run, but over ten years or more, the market itself tends to be stronger.
Why is that? One simple reason is active management costs more. Running an actively managed fund requires a staff of expert managers, researchers, analysts and traders who evaluate a great deal of information in order to make decisions. Managers of active mutual funds typically conduct intensive research on the individual companies they invest in, often traveling the country-or the world in the case of international funds-to see manufacturing plants or oil fields and meet with company management.
As a result, investors in actively managed mutual funds pay significantly higher fees than do investors in index funds. “The average expense ratio for passive funds was just 0.18% in 2015, compared with 0.78% for active funds,”2 according to Morningstar, the investment information and asset management company. Many actively managed funds charge far higher expenses, especially if they invest internationally.
Index fund managers, on the other hand, are not making decisions about what companies to invest in. Instead, they work to ensure that the fund is invested and weighted to accurately track its underlying index, typically with the help of computers, and periodically rebalanced so the composition of the fund remains consistent. Sometimes indexes rely on the size of each component company to balance the portfolio. In other cases, index creators add other economic criteria, including factors such as profitability and relative cost, to build the composition of the index. These processes require fewer (expensive) hands than active management, and as a result, passive ETFs and funds are typically cheaper to own.
There are studies galore that attempt to show which investing approach is more successful for various types of assets. Individual investors should understand the difference between active and passive investing along with the pros and cons of each, and with our help, choose the approach they think makes best sense for them.
In the end, what’s most important to keep in mind is aptly summed up by another quote from the Oracle of Omaha: “The money is made in investments by investing.”3