One of the most hotly contested debates in finance is the argument over which is better – active or passive investing. Moreover, this debate has spurred numerous academic studies that claim to identify whether passive outperforms active investing or vice versa. As a result, the current popular opinion suggests that passive outperforms active investing the majority of the time. However, the percentages can vary by a significant degree depending on who’s performing the study. Personally, I have seen numbers such as 85%, 91% and perhaps more commonly some will just say that the majority of actively managed funds fail to beat passively managed or index funds.
On the other hand, what I have yet to see is a clear definition of what an actively managed fund or portfolio really is. This has always been my biggest issue with these academic studies. The concept of passive is often more clearly defined as an index fund or portfolio. In other words, passive management is comprised of portfolios that mirror or match an index such as the S&P 500, etc. However, I have yet to see a clear definition of what constitutes or defines active management. Nevertheless, based on these criteria, I can only assume that any fund or portfolio that is not index based is included in the active management universe.
So my question is; how do you define active? Is it based on the amount of turnover in the portfolio, and if so, does every active manager in the studies have the same level of turnover? What strategies are being employed? Are all the active managers investing for growth, income or a combination of both? It seems to be clear what passive strategies are comprised of, but it is very unclear as to how the active category is defined.
But perhaps even more relevant to my skepticism is the implicit assumption that there are only 2 kinds of investing strategies-passive or active. Furthermore, these terms would also suggest that portfolio turnover or activity is the key differentiating factor. This really confuses me because even an index fund like the S&P 500 has turnover. In other words, stocks regularly come into and leave the index. Therefore, even an index fund has activity. So my question is; is there an activity or turnover standard or threshold that defines a portfolio as active? Furthermore, are these studies suggesting that any portfolio that is not an index has high turnover?
Therefore, one question I have, among many, would be; does a buy-and-hold long-term investing strategy fall into the active side or the passive side of the debate? For example, if an investor builds a portfolio of let’s say 30 stocks and never sells any of them, is that investor considered an active investor or a passive investor? Believe it or not, I have known investors that have done precisely that. They have bought and held stocks for decades.
And even more to the point is the undeniable reality that there are numerous investing strategies and many of them are not designed to beat the market. Instead, and for example, there are strategies designed to produce income, there are strategies designed to mitigate risk and there are strategies designed to meet specific investor objectives – and many more. Therefore, I consider the raging debate of active versus passive investing nonsensical. Attempting to define the broad universe of investing strategies as either active or passive is simply too restrictive and/or general to be of any real value.