Silly Season for the Active/Passive Debate

Last year was a great time for indexing. This year is a great time for indexing. Next year, there's a 70% chance that it will be a good time to index.

Man, the notions being pushed about indexing make my head swim. I've heard a number of silly arguments on both sides of the passive versus active debate. With salespeople and advocates aiming to make a buck for their side, you get a lot of misinformation. Let's take a look at them one by one.

1. "Actively managed funds lost a lot of money in 2008, so why pay their fees when I can index?"
But the funny thing is that stock index funds lost money during the bear market, too, so why does the bear market justify one's existence over the other? The biggest index fund,  Vanguard 500 (VFINX), lost 37% in 2008 while large-blend funds on average lost 37.8%. Yet, a large pension fund manager was quoted as saying that this was a clear sign that active management doesn't work. I guess that was the most important 80 basis points in history. Underlying this argument is the idea that somehow an active manager should be prescient and move in and out of the stock market at just the right time even if that means violating his prospectus. But then, if your goal is some sort of brilliant market-timing, don't look for an index fund to provide any. They are 100% invested through good and bad times. Moreover, 2008 wasn't a year where you could have picked the right stocks and stayed out of trouble, as in the previous bear market. Nearly everything suffered a double-digit loss.

2. "This year is a great time for active management as evidenced by the fact that such a large number of active funds are whomping the S&P 500."
This has two equally flawed bits. Part one assumes that you can predict when you should index and when you should not. I really doubt this, and when you consider that the point of indexing is to keep costs low and be patient, it doesn't make sense to rack up a tax bill and possibly commissions by hopping back and forth.

Part two is the often-repeated mistake of comparing all actively managed funds with returns of the S&P 500. That's just silly. Nearly all actively managed funds have lower average market capitalizations than the S&P 500. Even most large-cap funds will hold some mid-caps and have some big positions in the smaller end of large caps. So, when you make this comparison, you learn nothing about "active versus passive" and everything about small- and mid-caps versus large. Until very recently, small- and mid-caps had strongly outperformed large, helping funds that emphasize those market cap bands handily outperform the S&P. That's got nothing to do with indexing.

3. "95% of active funds lose to the S&P 500."
Note that, above, I said "index funds," not "indexes." Another thing that drives me crazy about this debate is that indexes, which have no expenses and can't be owned, are often used as proxies for indexing while the average active fund stands in for active management. Yet the argument also assumes that the investor in active funds is too feeble to discriminate at all among active funds. In fact, most money in active investments goes to funds with below-average expense ratios.

4. "Index funds have lower costs than active funds."
This one is mostly true. Index funds generally cost less than actively managed funds. But sometimes active funds can be inexpensive, and sometimes you'll find high-priced index funds. Reaching your goals is much easier if you focus on low-cost funds, whether active or passive.

5. "You should index your stock investments but have active bond management."
This is kind of odd, as Treasuries have low yields and no default risk. Thus, low costs and passive management (or investing directly yourself) seem like good ideas, at least for Treasuries. People who make the assertion that bonds shouldn't be indexed also seem to ignore bond index-fund performance during 2008, a year in which most active funds intermediate-term funds dramatically underperformed the Barclays Aggregate Index. Again, that was partly because of a mismatch of funds and indexes. The Barclays Aggregate Index is government-heavy, and active funds naturally tend to go outside government debt in an attempt to add value. However, when several institutions went belly-up in part because of their shaky balance sheets last year, people only wanted debt that carried a government guarantee, so the Barclays Aggregate thumped active funds.

Think Long-Term
Don't let all the noise in this debate throw you off. The best time to decide how much you have in active and how much you have in passive is when you are building your long-term investment plan. Low-cost actively managed funds and low-cost index funds are great ways to build your portfolio. The cheapest index funds will usually lower your costs even more than the cheapest active funds.

Because index funds are dependable, look to use them when you can't find an outstanding low-cost active fund or to simply reduce the total dollar amounts that you are spending on fees. They are also a handy way to reduce the time that you spend tracking your investments. If you feel that you can't keep track of all your active funds, cull a couple of weak ones and put that money into index funds where almost nothing ever happens. Once you buy them, watch your funds, but be patient. In either case, the benefits of low costs or strong active management pay off slowly. In 15 or 20 years, you'll see how much they've helped you to reach your goals.

To see our list of recommended index funds and actively managed funds, go  here.

A version of this article appeared July 20, 2009.

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