What’s better for your equity portfolio – index funds or active management? The debate has been going on for decades and index investing has grown in popularity over the past 20 years. It is a complicated subject with no indisputable answer that applies to everyone. However, 2020 has been helpful in setting the context and examining the facts. With a crazy year behind us – and more turbulent market conditions ahead – now is the time to revisit your investment strategy to ensure that you are making the best decision for long term returns.
Active management, a source of controversy
The argument for indexing is simple and compelling. Index funds have produced simple, reliable and sufficient growth for most investors. S&P 500 returns have been positive in almost every 10-year period in history, and even the biggest crashes have been followed by bull markets. As the global economy grows, indexing should lead to long-term gains that far exceed what you’ll get from most bond portfolios, savings accounts, money market accounts, or CDs. . All of this can be delivered without the risk inherent in active strategies and, most importantly, without management fees that erode your earnings year after year.
That’s pretty compelling stuff. Nevertheless, some investors will point out that indexation also has flaws and shortcomings. Passive investing will produce results that are suitable for most people. However, it will never provide returns tailored to individual goals and risk tolerance. Also, index funds can only go one way when stocks are going down. Market cycles are inevitable, so there will be years when passive investments lose money.
Active managers, on the other hand, can allocate stocks that will rise faster in bull markets and fall less in bear markets. They can even profit directly from crashes by hedging themselves with options or short positions.
Fund managers try to create value for their clients by anticipating market movements in advance and building a portfolio accordingly. Anyone can generate returns when the overall market is up – it isn’t when stocks are beaten. Active managers often aim to eliminate catastrophic losses from stock market crashes, and that is why many people still believe in it.
Active management still hasn’t outperformed in 2020
During bear markets and volatile times, investment talent is said to shine. Sophisticated investment strategies can generate returns in any situation. Day-to-day volatility creates opportunities for greater gains than you get in calm markets. It’s harder for fund managers to justify their value when the market pushes everyone up. If active management cannot clearly come apart during more difficult times, the credibility of the whole approach is threatened.
With that in mind, it does not bode well for fund managers that most US equity funds have lagged the total market for the full year of 2020. Studies have shown that active managers have lagged behind the total market. also struggling to beat the indices in the middle of the year. More worryingly, the past year has actually been one of the most successful years for these investors. Fewer funds have outperformed the indices during the bull market of the past decade.
2020 has been the busiest time for stocks since the Great Recession, and it should have been a bumper year for active strategies. Instead, supporters of passive investing have gathered more ammunition to support their position.
A few nuances before deciding that the debate is settled forever
Just because most active strategies fail to generate superior net returns over the long term, we can’t assume they’re all bad. Some of them do beat the market, although this is quite rare. In addition, each has different goals and risk tolerance. It may be wise to devote a portion of your portfolio to an actively managed fund. They might be more effective at minimizing risk or maximizing growth, depending on your personal situation.
There are also shades of gray between active and passive investing strategies. For example, you can buy ETFs that track niche indices rather than the entire market. These could be specific geographies, equity sectors or industries with varying risk and reward profiles. Examples would be growth indices with a higher upside or quality / dividend indices optimized for stability and income rather than growth. The use of this type of strategy is not purely passive, since it is necessary to allocate to various niche index funds. It can also be something that you can do on your own without incurring any professionally charged management fees.
There are also ârule-basedâ strategies that are considered semi-passive. Factor investing, for example, does not rely on stock selection or market timing per se. This type of strategy allocates to a smaller range of stocks and selects portfolio weights based on characteristics different from those used by simple index funds.
Ultimately, you need to determine your overall goals and your risk appetite. The best strategy for you isn’t necessarily the best for someone else, so you need to weigh the pros and cons of any investment approach when it comes to your personal financial plan. Both passive and active investing strategies have their advantages, and many people would even benefit from combining the two.