In investing, there’s a competition that’s a lot like “The Tortoise and the Hare.”
Remember the story? The tortoise, exasperated with the hare’s incessant antagonizing, challenges him to a race.
Our industrious tortoise doggedly pursues his objective. But the hare, confident of his victory, takes several detours. Hearing the commotion in the distance as the tortoise approaches the finish line, the hare makes a furious dash — only to lose to the tortoise by mere inches.
The moral: Slow and steady wins the race.
There’s a parallel in the debate between active management vs. indexing.
Active management is viewed as the faster, sleeker, more sophisticated approach to investing.
Indexing, on the other hand, with its low fees and academic theorizing, is seen as a strategy for ivory tower academics and unsophisticated investors.
But which one is the better investing strategy?
What Is Indexing?
First off, let’s distinguish between an index — a noun — and index-ing which is an approach to investing.
An index is simply a list of securities — usually stocks or bonds — grouped together according to some predetermined criteria, such as:
- Price
- Percentage of overall market value
- Location (domestic vs. international)
- Revenue growth
- Credit quality
Some examples of larger indexes you may have heard of include the . But there are literally thousands of indexes measuring just about every kind of investment or investment strategy imaginable.
Indexing is the act of investing in a particular type of investment vehicle, such as an exchange-traded fund, that tracks an underlying index.
Frequently, indexing is described as “passive” management, though this is somewhat of a misnomer for two reasons.
First of all, passive investing can include investment strategies beyond indexing. Buying and holding onto a handful of stocks, for example, can also be considered a passive approach to investing. Indexing, on the other hand, is a specific approach to investment management that seeks to replicate and track the performance of a particular market index.
Secondly, replicating an index by trading the individual stocks or other securities is an incredibly intense and proactive endeavor.
What Is Active Management?
Active investment management is any investment decision that rests on the assumption that an investor will be able to earn better returns than the market average, as reported by one or more indexes.
The index is used as a benchmark to measure an investment manager or strategy against.
Intuitively, active investment management makes all the sense in the world.
Shouldn’t anyone with a little business savvy should be able to discern a superior investment opportunity from an inferior one? And shouldn’t professionals who spend most of their waking hours analyzing investments and the economy be that much more likely to improve upon the performance of the collective masses constituting the “average” investor?
The answer is frequently “no.”
Indexing vs. Active Management: Which Is Better?
Hands down, the primary advantage of indexing vs. active management is the cost.
Without an army of analysts, office space and other overhead, index funds and ETFs can be managed for very low costs.
Consider the difference in the expense ratios, which is the fee for managing an investment and is calculated as a percentage of its total value.
Most actively managed investments (usually mutual funds) charge around 0.5% to 1.5% in management fees. But an index fund may cost as little as 0.1%, or $10 for every $10,000 you have invested.
Some brokerage firms have even begun to offer their own proprietary funds linked to various indexes for ZERO management fees. (Don’t worry — they still make money in other ways.)
Most active investment managers fail to outperform their indexed counterparts.
Even the best active investment managers have, historically, only managed to outperform their respective benchmarks by around 0.25% to 0.5% after fees. Most do not even break even.
Considering the likelihood of identifying these successful managers in advance in the first place, this is hardly enough to alter the fundamental principles of sound financial management.
Does that mean that there is no role for active investment management at all? Not necessarily.
Proponents of active management argue that as the number of active managers and the fees they charge decline, the opportunity for active investment management could improve.
The Moral of the Story: Just Keep Investing
The choice between active management vs. indexing — even after taking fees into account — is FAR less important than deciding how much to save (or spend) in the first place.
Investing in a well-diversified portfolio, whether indexed or actively managed, eliminates your risk of losing all your savings because a single company goes into bankruptcy or default.
While you can eliminate this type of risk by not investing in a single company, you can’t eliminate the risks associated with the market, no matter how diverse your investments are. Such risks include:
- Recession
- Runaway inflation
- Political turmoil
- Anything impacting investor sentiment
But indexing is hardly a low-risk alternative to active investment management.
As anyone who was invested during the dot.com bubble or 2008 financial crisis will tell you, although (relatively) rare, stock index funds can and do lose 50% or more of their value — depending on the type of stocks owned by the fund — during a severe market downturn or financial crisis.
It’s important to consider your risk tolerance relative to your objectives.
From there, you can set realistic expectations for the returns you can expect from investing, choose an asset allocation that’s appropriate for your risk tolerance and decide on an appropriate amount to save each pay period to have a reasonable chance of achieving your goals.
Whatever investment strategy you decide is a fit for you, be sure to go into it with a firm understanding of what you should expect.
At that point, whether you’re a tortoise or a hare, you should be well on your way to successfully running your race — no matter who comes in “first.”
David Metzger is a fee-only wealth manager in Chicago. He is a certified financial planner (CFP) and a chartered financial analyst (CFA). He has taught courses on personal financial planning and investing at DePaul University in Chicago and Christian Brothers University in Memphis, Tennessee.
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As an experienced financial expert with a deep understanding of investing, let's delve into the concepts introduced in the article about the ongoing debate between active management and indexing.
Indexing:
Indexing is an investment approach that involves tracking and replicating the performance of a specific market index. An index, in this context, is a list of securities (stocks or bonds) grouped based on predetermined criteria. Examples of such criteria include price, percentage of overall market value, location (domestic vs. international), revenue growth, and credit quality.
In the context of investing, an index becomes the benchmark, and investors can opt for investment vehicles such as exchange-traded funds (ETFs) that mirror the composition and performance of the chosen index. Despite being termed "passive," indexing involves proactive efforts to replicate and track the chosen market index.
Active Management:
Active investment management, on the other hand, assumes that investment professionals can outperform the market averages by making strategic investment decisions. In active management, investment managers or strategies are benchmarked against one or more indexes to measure their performance. This approach relies on the belief that skilled professionals can identify superior investment opportunities and generate higher returns.
Comparison:
The article highlights the ongoing debate between active management and indexing, drawing parallels with Aesop's fable of "The Tortoise and the Hare." The comparison emphasizes the cost factor, with indexing being portrayed as the slow and steady approach with lower fees, while active management is depicted as the sleeker but more costly alternative.
Cost Advantage of Indexing:
One of the key advantages of indexing highlighted in the article is the cost factor. Index funds and ETFs generally have lower expense ratios compared to actively managed investments. The lower costs stem from the absence of extensive research teams, office space, and other overhead associated with active management. The article notes that expense ratios for actively managed investments can range from 0.5% to 1.5%, while index funds may have costs as low as 0.1%.
Performance of Active Management:
The article asserts that, historically, most active investment managers have struggled to outperform their respective benchmarks consistently. Even the best-performing active managers have only managed to outperform by a margin of around 0.25% to 0.5% after accounting for fees. This challenges the intuitive expectation that professionals analyzing investments and the economy should consistently outperform the broader market.
Role of Active Management:
While the article acknowledges the cost advantage of indexing, it suggests that there may still be a role for active management, especially as the number of active managers and their fees decline. Proponents argue that with fewer active managers and lower fees, the opportunity for active investment management could improve.
The Moral of the Story:
The article concludes by emphasizing that the choice between active management and indexing is less crucial than the decision of how much to save or spend in the first place. It underscores the importance of investing in a well-diversified portfolio, whether indexed or actively managed, to mitigate risks associated with individual company failures. The overall message encourages investors to focus on risk tolerance, set realistic expectations, and align investment strategies with specific financial goals.
