Active vs Passive Investing: And the Winner Is …

Active vs Passive Investing: What’s the difference?

According to NASDAQ: “Passive funds track an index of stocks or bonds with a certain investing strategy in mind… Contributing regularly to a fund that tracks an index of diversified bonds or stocks, like the S&P 500, should get you to your goals.” The major advantage to this method is low cost and little chance for error.

Active funds on the other hand are managed presumably by “experts” who are able to beat the index. On the down side in exchange for potentially higher returns you must accept more risk as well. In addition fees are higher not only for higher transaction costs but also for management fees to pay the “experts”.

But, perhaps you’re not completely clear about WHY that difference is even worth talking about — then please stick with me as I offer a fast summary.

Active Funds:

Active funds include the human element — as in, a fund manager or managers.

Investors who invest in active funds want  a manager who can identify trends in a securities market or market index, of stocks or bonds or money market instruments — the fund manager sees opportunities in that market, and decides to allocate the fund accordingly.

Passive Funds:

The vehicle of choice for passive investing is, the Index Fund. Put simply, these funds track an index — like the Dow or NASDAQ — and wherever the index goes, the fund follows.

Back in the 1945 Austrian Economist Frederic Hayek argued that self-interested traders are motivated to acquire and act on their private information. In doing so, traders contribute to more and more efficient market prices.

The efficient-market hypothesis (EMH) states that asset prices fully reflect all available information. The EMH was developed by Professor Eugene Fama who argued that stocks always trade at their fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by chance or by purchasing riskier investments.

Shortly thereafter (in the bear market years of the 1970s) index funds were created . Yet, participation was almost nonexistent until after 1985 — when the great bull market was already underway.

Yet, unlike U.S. stock indexes themselves — which saw two huge declines in the first decade of the 2000s — the growth of index funds has gone in only one direction — up for three decades indicating that people believe the EMH to be true.

The chart below comes from a new report from our friends at Elliott Wave International and shows the growth of the passive investment.

It’s as straightforward as it looks — not much need for animation.

The index funds share of equity mutual funds today exceeds 35% percent, and the trendline is getting steeper.

Total index investing today exceeds 4 Trillion dollars.

What this chart shows us is how the passive investing trend accelerated in 2016. For the year, 286 billion dollars flowed OUT of active funds — a record amount…

… And it’s no stretch to infer that at least some of this outflow became the inflow into passive funds — some 428.6 billion dollars flowed into active funds in 2016 — also a record.

So the question is — why? Why has the share of index fund investing gone from basically zero in 1985, to more than 35% in 2016?

Why have an ever-greater number of U.S. investors entrusted their money, not to experts, but to the assumption that the stock market itself can just take care of their investment?

These and MANY other questions are answered in Elliott Wave International’s annual State of the Global Markets Report. See below for more details.