Active versus Passive Investing – Why Passive is best for Stocks and Active is better for Bonds
Is active or passive investing better for the average investor? The active versus passive investing debate has existed for longer than most of us have been alive, starting from Jensen (1968), updated by Malkiel (1995). Yes, the same Malkiel who wrote A Random Walk Down Wall Street. While entire forests have been chopped down for the papers on active versus passive investing, there is still no conclusion to this debate. Why? Because both active and passive funds exist even today. This should not be the case if there is a clear conclusion. And does active or passive investing work better for stocks or for bonds?
Active Versus Passive Investing
Not even the exhaustive research that S&P Indices Versus Active (SPIVA) does has deterred asset managers from finding a way to try to beat the market. Here’s what their latest results show, firstly for active fund performance in different countries:
SPIVA Index Versus Active Results for Different Countries
Next, the results for equity funds in the US. Remember, these were the focus of the research started by Jensen (1968) and Malkiel (1995):
SPIVA Index Versus Active Results for US Funds
And finally the results for international funds, which goes against the received wisdom that there are more market inefficiencies in the financial markets of developing countries, which allow active fund managers to outperform the index:
SPIVA Index Versus Active Results for International Funds
But there are areas where active investing still work!
So, that should settle the active versus passive investing debate, right? Not really. Believers in active investing will point out that that Warren Buffett, George Soros, Jim Simons amongst other investing giants have come out ahead of the market index over a long period of time, even if they did not strictly benchmark themselves to a market index like the S&P 500. SPIVA’s own research show that there are areas of investment, where active investing has outperformed passive investing in the market index for a long period of time, both for stocks and for bonds:
Percentage of Funds Underperforming the Index
|Fund Category||Comparison Index||5 years||3 years||1 year|
|US Mid Cap Growth||S&P Midcap 400 Growth||31.25%||18.55%||17.16%|
|US Small Cap Growth||S&P Smallcap 600 Growth||32.82%||19.57%||13.71%|
|US Investment Grade Intermediate Bonds||Barclays Intermediate Government/Credit||41.12%||44.55%||33.51%|
These results are curious. They show that there are still possibly pockets of inefficiencies where active investing may still make sense. But we should not take these results too far. In the case for the equity funds, the instances where the active investment managers beat the index may be the result of taking on additional illiquidity risks, or bankruptcy and failure risk, which does not show up in the index. This is on top of the risks for low Price-to-Book ratios (i.e. Value stocks) and Size, which have been shown to be significant drivers of returns in the three factor model of Fama and French (1993). Stocks of companies which fail and close are removed from the index, so the index returns ignore this risk.
But does the same hold true of the active investment grade bond funds? Let’s look a bit more in detail at this question.
Why passive investing works for stocks
Firstly, let us consider why passive investors in equity index funds or ETFs tend to come out ahead of the index, and not just due to the lower fees that the funds charge. As any good stock trader knows, one of the key disciplines which make for successful trading is being able to hold on to your winners and sell away your losers. In layman terms, this is commonly known as momentum, where stocks which are rising tend to continue to go higher, while stocks which have fallen will also continue doing so. This has been first shown to be a significant fourth factor in stock returns by Cahart (1997).
Now let us consider a simple portfolio in an alternate universe where there are only 2 stocks in the market, Able Company (A) and Bozo Company (B). Suppose these two companies start off with a market value of $100 million each, and their share price is $100 per share. A market cap weighted portfolio of these two stocks can be just one stock of A and one stock of B.
In period 2, suppose the price of A’s stock went up 50% to $150, while the price of B’s stock went done 10% to $90. Similarly, the market cap of A rises to $150 million, while that of B drops to just $90 million. But without doing anything, the passive 2 stock portfolio has automatically adjusted to hold these two stocks in exactly the same proportion according to their market cap!
A passive portfolio automatically adjusts for the changes in the market cap of stocks
|Value of Stock A||Value of Stock B||Portfolio Value|
|Period 1||$100 (50%)||$100 (50%)||$200|
|Period 2||$150 (62.5%)||$90 (37.5%)||$240|
Moreover, the automatic adjustment of the weights of the two stocks in the passive portfolio also fulfil the trading rule mentioned above – momentum. Basically, we now hold more (in value) of the winning stock, A, and less of the losing stock, B. In the real world case where there are many, many more stocks in the index, the losing stocks get a smaller and smaller weight in the portfolio, until they drop out of the index. At that point, they are removed (i.e. sell away the losers) and replaced by – guess what? – winning stocks which have gained enough to be put into the index with the other leaders.
Of course, you can quibble whether you should have held 20% to 40% in a wining stock like Apple (as in Berkshire Hathaway’s 2020 portfolio), versus the 7.5% weight Apple has in the S&P500. Regardless, a passive stock index portfolio allows you to at least capture some of this upside in Apple stock (and many other winners), all without doing anything! Hence, passive, rather than active investing, makes a lot of sense when we look at stock investments.
Why active investing works for bonds
So, does passive investing works for stocks but does active or passive investing work for bonds? As we see from the SPIVA data, unlike stocks, there is a better chance for active investing in bond funds to outperform passive investing in the index. This is further supported by the data from Morningstar below for stocks and for bonds as well:
Why is it that active bond funds can outperform the index, whereas equity funds cannot? There are several reason for this:
- Bond indices contain many more bonds, in the thousands, compared to stock indices, so it is much harder and more costly to run a truly passive bond fund
- Because each company can issue many bonds, but only one class of stock, it is possible for an active investor to find mispricing and undervaluation of bonds from the same company. Usually, this means playing around with maturity, coupon, subordination, credit ratings etc.
- Bond indices usually contain the most recent bonds issued. Hence to track the index, passive investors need to sell away the older, less liquid bonds (sell low), and buy the newer, more liquid and hence more expensive bonds (buy high)
The biggest advantage active bond investors have over passive investors, is the ability to choose when to sell their bonds. How does this work in practice? Let’s illustrate this with a simple example. Suppose we have the yield curve of bond interest rates as shown below:
Illustrative bond yield curve
Further, let’s suppose that we buy a new 10-year bond, with a coupon of 2%, based on the yield curve. Obviously, the bond will be priced at $100 today, since the coupon rate matches the bond interest rate. And obviously, when the bond matures in 10 years, it will also be worth $100. How will the price of the bond change over time? If the bond interest rates do not change, the value of the bond will first rise over time, then fall. We show this below:
Pull to Par for a bond
Why does this happen? Well, in a year’s time, our new 10-year bond will become a 9-year bond, but with a coupon higher than the 9-year bond interest rate. And the same happens in 2 years’ time when it becomes an 8-year bond. But after 5 years, while it still pays a coupon higher than the 5-year bond interest rate, there are fewer coupon payments left, so the value then declines back to $100. This phenomenon is known as “pull to par”.
An active bond investors can simply take advantage of this and only sell the bond when the value peaks in year 5. A passive bond investor, however, cannot do so, because it must sell the bond when a new 10 year bond is issued, maybe 6 months after the first bond was issued. What this means is that the passive bond investor will always be selling the bonds at around the same price as they bought them, making it so much harder to outperform the index.
So when it comes to active versus passive investing, the answer differs for stocks and for bonds, with passive investing being better for stocks but active investing being better for bonds.
Can I actively invest in bonds by myself?
If there are so many ways to actively invest in bonds, can I do it by buying bonds directly myself? Unfortunately, the answer is no. The biggest risk driver for bonds are interest rates, so it is not easy to build up a diversified portfolio of bonds, since all of them have the same risk! If it takes 10 to 30 different stocks to constitute a diversified portfolio, the same level of diversification for bonds requires hundreds of bonds! So it is just not possible for the average investor to build up an actively managed portfolio of bonds.
But it doesn’t have to be so hard either. Previously, we have shown that there are many active bond funds with pretty decent returns:
Sample of bond funds available
Hence, it has been possible to invest in bond funds which pay out a dividend of around 4% a year, and still give about 1% gains per year. Such a performance is better than passive bond funds which match the index total returns of roughly 2% per year. So even while passive investing is the correct answer for investing in stocks, active investing should definitely be considered for the bond portion of the portfolio for the average investor.
Finally, one of the great things about bond fund investing is that it allows you to invest safely with leverage. More on this in a later post!
But there is no such thing as truly passive investing for the average investor!
But finally, let us leave you with a thought to ponder. One extreme stance in the whole debate is that there is really no such thing as truly passive investing. How so? As Brinson et al (1991) showed, more than 90% of differences in returns on professionally managed investment portfolios come from investment policy. Or in layman terms, the portfolio asset allocation. Incidentally, they also found that the the returns to active investing were negative! As an investor, even if you only invest in passive Exchange Traded Funds (ETFs), you still need to select an asset allocation, whether it is 40% in bonds and 60% in stocks, or vice versa. This allocation decision, at the end of the day, largely determines the investment returns, and has to be consciously taken.
Hence there is no such thing as truly passive investing!
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