Broker Check

Should We Just Give Up?

September 29, 2023

Active investing attempts to outperform a benchmark or target specific goals. Passive investing attempts to return the same performance as an index, no better or worse. Thanks to years of strong financial markets and frustration from active manager fees, passive funds have gained a significant share of investors’ wallets. According to ISS Market Intelligence, index funds will control over half of long-term invested assets by the end of 20271.

If the trend favors index funds, going passive is tempting. Why pay an active manager when they can’t consistently beat their index? It’s a valid question, so here is a three-question test to help determine if you’re suited for passive investing.

Do you need income?

Passive investing is not an option if you require income from investments. The dividend yield on the State Street S&P 500 index fund (ticker: SPY) is 1.53%. The yield on the iShares Barclays Aggregate Bond index fund (ticker: AGG) is 2.86%2.

No mathematical combination of these two could beat most broad measures of inflation after taxes. For retirees facing medical costs, grocery bills, and rents that continue to rise faster than headline inflation numbers, it’s doubtful that this income stream can come anywhere close to what’s needed.

Do you have time?

Younger people typically select cheaper healthcare plans with less coverage because they tend to be healthier. However, they often move to more comprehensive and expensive plans as they get older.

The same applies to investing. Younger investors may not need an active manager's expertise and associated cost because they have decades before they will access their nest egg. This runway provides some protection from volatility.

A good rule of thumb for passive investing is a minimum holding period of ten years because a decade tends to be enough time to capture a full cycle from boom to bust. If a recession were to happen, the investor would hopefully gain enough to endure a sharp decline late in the cycle or have time to recover from one early on.

Can you keep it together?

A common misconception is that going passive is easy. Simply sell actively managed funds and replace them with index funds that target a risk tolerance. However, index funds and passive investing are not synonymous, and passive investing is not easy.

Index funds are a vehicle, not a strategy. They are used as much by active investors as by passive ones. Since they offer cheap exposure to asset classes, sectors, and styles, active managers use them for tactical asset allocation (moving from stocks to bonds) and hedging (protecting against unexpected events).

Passive investors use index funds but hold through thick and thin. If the S&P 500 falls 50%, as it did during the financial crisis, they do not sell. This discipline is anything but easy and can test the resolve of even the most committed investors.

The chart below shows the annualized returns for various asset classes. Average investors (red bar) earned a fraction of a balanced portfolio (purple bars) and barely beat inflation (black bar).

Source: J.P. Morgan Asset Management – Guide to the Markets, 3Q 2022

Most investors underperform because they chase performance and sell into panic. Therefore, ask yourself if you can sleep at night when the next crisis rocks the stock market. Because it’s one thing to say you can tolerate a downturn, but it’s an entirely different thing to take that ride. If you are susceptible to panicking, then pass on passive investing.

The bottom line

The Capital Group is one of the largest asset managers in the world, and they conducted a survey that produced two alarming statistics3:

  1. Roughly 80% of investors between 50 and 64 years old and 75% of those over 65 consider protecting gains from market downturns a priority.
  2. Only 53% of respondents were aware that index funds expose investors to the full ups and downs of the market.

If the majority values protection, but only half realize that index funds provide no protection, then a big chunk of the assets moving into passive strategies could be misaligned with their goals.

The chart below further complicates this debate by showing that while passive has outperformed active since 2012, the long-term story is more cyclical. Perhaps the recent outperformance of passive was helped by the Federal Reserve keeping interest rates close to zero over the last decade. Doing so flooded investments into stocks to find a decent return, and that rising tide lifted a lot of ships that many active managers didn’t buy for one reason or another.

But now that interest rates are higher and likely here to stay, disciplined approaches that rely upon strong fundamentals and attractive valuations may start to matter more. We think they will, and that’s why we are looking closely at our strategies for ways to get more active.

The bottom line is that “active versus passive” is not a useful debate because they both have their place. Just be sure that you are not putting a right shoe on a left foot.





2 Bloomberg. As of 9/28/2023.




This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.