The “active vs. passive debate” has raged on for a long time in the field of investing. Where actively managed funds aim to outperform the market through complex strategising, passive investing is more about matching market performance through tracking a specific index. In this video, Professor CRAWFORD SPENCE looks at the difference between the two styles, and the wealth of research on their effectiveness.
TRANSCRIPT
Robin Powell: A key decision investors need to make is whether to use actively managed funds or passively managed funds. So what exactly do we mean by active funds, and how do they differ from passive? Here’s Crawford Spence, Professor of Accounting at King’s College London.
Crawford Spence: Actively managed funds try to beat the market, they try to do better than average. The language in the field is “generating alpha” – that’s what they use, the Greek letter “alpha” – to talk about generating better than average returns. So it’s all about picking winners and losers in the stock market, and betting on the winners – or the losers, if you’re going to short sell them. There’s different ways to do that: it can be through conventional stock picking, fundamental analysis, bottom-up stuff, or more quantitative investing, a bit more systematic factor-based investing – but the ethos there is really to try to do better than average, to generate an alpha.
RP: So, that’s active fund management. And, for many decades, active was by far the most popular way to invest. Let’s look now at passive investing, which – in recent years – has been gaining ground on active, and in many areas, overtaking it.
CS: Passive investing doesn’t try to be better than average. It absolutely tries to be average. So, instead of generating alpha, it does what they say: “tracks beta” is the language they use in that space. So you’ll take, say, a basket of stocks – maybe a weighted average of the FTSE100, for example, or maybe the Standard & Poors 500 – and you’ll just have a weighted portfolio in that index, and you’ll just put your money in there and basically leave it. Track the index over time, every six months or maybe a year, your portfolio will rebalance; and the idea is really to generate consistent returns over a long- term basis.
RP: So, in a nutshell, those are the differences between active and passive. The all-important question is, which one’s better?There is, in fact, a clear winner.
CS: So the academic evidence has been pretty clear on which is better – active or passive investing. And this is nothing new: we’ve known for decades now that, really, over the longer term, passive investing delivers much better returns to investors. For example, any given year, you might find half the active fund managers outperform the relevant benchmark (meaning they beat the market). However, if you fast-forward to, maybe, three, five, or ten year time horizons; the number of active fund managers who beat their benchmarks really dwindles quite rapidly – to the point where, if you look at a fifteen year time horizon, almost nobody beats the market in the active fund management space. And those people can’t really be identified ex ante. You don’t know who they’re going to be beforehand; and the other complicating factor is, you don’t know if they’ve beaten the market because of skill or because of luck. So, you’re really talking about a very narrow number of people who are very hard to identify, and you don’t know why they’ve beaten the market either.
RP: Despite the overwhelming evidence against using actively managed funds, there are still many financial advisers who recommend using them. So be sure, when choosing a financial adviser, that they’re fully aware of the academic research that Professor Spence refers to.
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