Active Management Versus Passive Investing: How to Choose

Active management fees, coupled with periods of underperformance, have made low-cost index investing attractive for investors, writes Validea CEO John Reese in a recent article for The Globe and Mail.

Indexing, Reese explains, was developed as a way for investors to track the market’s return while maintaining diversity and avoiding the time and risk associated with finding the right active manager.

The article cites Morningstar data showing that, last year, the flow of funds into passive strategies totaled $505 billion, while $340 billion was withdrawn from active management. The trend, writes Reese, ‘is upending the asset-management industry.” He notes, however, that shifting dollars from active to passive strategies still requires investors to maintain resolve in riding market ups and downs. “Many investors seem to forget,” says Reese, “that between 1999 and 2009, the S&P 500 effectively went nowhere.”

An investor can still find a good active manager, Reese argues, but will tend to make decisions based on trailing 3-5 years’ worth of returns—not a sufficient amount of time to evaluate performance. Reese outlines a number of questions an investor should ask a prospective active manager before evaluating a performance record to understand their investment process and whether it is consistent and repeatable. He recommends taking a look at the manager’s long-term track record (at least 15 years) and the market environments that coincided with periods of underperformance.

If an investor conducts the appropriate amount of due diligence, they stand a better chance of finding an good active manager, says Reese. Otherwise, he asserts, “you’re probably better off in index funds.”