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Active Investing vs. Passive Investing

By Scott Roark, MBA, PhD | September 18, 2020

In this blog post, I want to talk about the characteristics of passive and active investing and how those terms relate to activities frequently associated with investing.

For a working definition, I am going to consider passive investing as the set of activities and decisions that is consistent with an investor seeking to match the performance of their benchmark.  The benchmark would be consistent with the level of risk that is appropriate for the investor – consider for simplicity a 60% equity, 40% bond (60/40) portfolio.

For active investing, a good working definition is the set of activities and decisions that an investor takes to beat the performance of their benchmark.  Again, the benchmark would be consistent with the level of risk for the investor.

Let’s talk about that most important of decisions for an investor – their asset allocation.  This is really divorced from the whole active/passive discussion – at least when talking about the strategic asset allocation.  This is a decision that is made with an eye on the risk appetite, stage in life, types of assets, amount of assets, presence of guaranteed secure income, etc.  For some people this might be a 20/80 allocation and for others perhaps it is 80/20.

While the strategic asset allocation doesn’t really touch on active vs. passive, the tactical asset allocation does.  This is where certain investors/strategists/managers will adjust their target stock/bond mix based on market conditions and more importantly where they think the market will go in the near future.  This is trying to beat the market by tweaking things.  For instance, if there has been a big run up in equities, perhaps the active investor will decrease their allocation from the target 60/40 allocation to 50/50 because the fear is that the market will have a correction and by tweaking the asset allocation, the portfolio will do better than the 60/40 benchmark.

There is another important part to this asset allocation discussion.  In the absence of rebalancing a portfolio, an investor who does nothing after a run up in equities is really making an ACTIVE decision to be overweight equities because they will most likely have a higher proportion of equity than their target allocation.  It is a bit of a paradox, but by neglecting the account, the investor is effectively making a bet that they will do better than their 60/40 benchmark.  So periodic rebalancing is actually an important part of PASSIVE investing – keeping your portfolio allocated in a way that is consistent with your benchmark.

By far the most common characteristic of investing that people think about in the active vs. passive discussion is the actual investment they are picking.  A broad-based market index like the total stock market index or the S&P 500 index is a passive approach to the choice of what to buy.  Buying a mutual fund where the fund manager is trying to uncover undervalued stocks, on the other hand, is consistent with an active approach to investing.  Typically, there is a direct cost involved here.  Passive index funds or ETFs typically have VERY low expenses (less than 0.1%).  And while the expense ratios associated with active funds have come down dramatically over the years, many of these funds are still close to 1% (or more).  These higher fund expenses typically come at a cost to the investor:  Passive funds consistently beat actively managed funds over time.  A recent Morningstar report (https://www.morningstar.com/articles/999669/busting-the-myth-that-active-funds-do-better-in-bear-markets) showed that less than 10% of actively managed large cap funds beat their passive benchmark over the most recent 10 year period ending in June 2020.  For all funds (large, mid, small, international, etc.), only 24% of actively managed funds beat their passive counterparts over that time.   The biggest reason is those fees.

There is one other critical component to the active vs. passive discussion and that is the amount of trading and attempted market timing involved.  Active investors try to time the market and are usually much more frequent traders than passive investors.  This usually leads to underperformance AND to tax inefficiency.  Study after study shows that investors who trade frequently underperform those who hold onto investments.  I’ve seen multiple reports of one particularly interesting study from Fidelity when they looked at which types of clients had the best performance between 2003 and 2013.  They found that the customers with the best performance were the ones who were dead or who were inactive (i.e. they forgot they had an account).  In other words, they were messing around with their investments – trying to time the market, buy the hot stock or guess which sector was about to take off.

While this is not an exhaustive list of all the ways an investor could try to “beat the market” (sector rotation, stock selection, interest rate forecasting, exotic investments, cryptocurrency, etc.), this hits on a few common differences between active and passive.

At our firm, we choose to use a passive approach to investing for a few reasons.  First, it has been shown over time to do well in comparison to benchmarks.  Jim has talked repeatedly in podcasts and we’ve had a number of blog posts that touch on the importance of benchmarking and the passive approach holds up well when comparing to the gold standard of performance.

Second, passive investing is a tax-efficient way to invest.  By minimizing trading, capital gains and the associated taxes are kept low.

And importantly, passive investing is relatively easy to implement and monitor.  With periodic rebalancing it is pretty easy to “set it and forget it” and look up after 5 or 10 years and be surprised at how well an account has performed – how much an account has grown (if you are in the accumulation phase) or how well an account has held up (if you are in the harvesting phase).

Why Investor Returns Usually Fall Short of Benchmarks

By Scott Roark, MBA, PhD | July 17, 2020

In podcast episodes and in past blog posts (10/25/2019, 4/20/2019) we’ve talked about the importance of benchmarking – comparing the investment performance on a risk-adjusted basis to an objective measure.

At Jim Saulnier & Associates, we use five Morningstar benchmarks that are adjusted based on risk tolerance.  The benchmarks are for Conservative portfolios (20% equity, 80% fixed income), Conservative Growth portfolios (40% equity, 60% fixed income), Moderate portfolios (60% equity, 40% fixed income), Moderately Aggressive portfolios (80% equity, 20% fixed income) and Aggressive portfolios (95% equity, 5% fixed income).  The Morningstar benchmarks we use consist of around 15-18 individual holdings that are a mix of domestic equity, international equity, large cap, small cap, mid-cap, long-term bond, intermediate bond, short term bond, international bonds, REITs, TIPs, etc.

We have designed our five “Convenience” portfolios to mimic these Morningstar benchmarks.  Jim has repeatedly stated in podcast episodes and in meetings with clients that we do not expect to beat the benchmark, but instead we fully expect to trail the benchmark to at least a certain extent. The reason is that there are several factors that act as a “headwind” for the investor and can mean their performance will not match the performance of the benchmark.  Below is a discussion of the biggest factors.  While this list is not an exhaustive list of everything that can hinder performance, it will touch on the main reasons that an investor might not see the same returns as the benchmark returns they are tracking.


The most obvious reason that an investment generally lags a benchmark is the fees involved.  These would include, but not necessarily be limited to, fees on the mutual fund or ETF that is used, fees from an investment advisor, fees paid to a broker-dealer and brokerage wrap fees.  A quick example with worst case numbers will quickly show why performance might lag a benchmark by quite a bit.

Assume that you have a relationship with a financial advisor that charges an Assets Under Management (AUM) fee of 0.75% per year.  This advisor outsources investment management to a 3rd party who creates a portfolio that is consistent with the risk tolerance of the client.  This investment manager would also charge a fee – let’s assume 0.40% per year.  Finally, there are likely fees in the mutual funds or ETFs held in the investment account.  Let’s assume that the funds are actively managed funds and that the fund fees are close to the average for large-cap stock funds and are equal to 0.85% per year.  All together these fees add up to 2.0%.  This means that if the investments earned 6.0%, you netted only 4.0% after paying the fees.  Even if the investment choices were perfectly aligned with the benchmark, you as an investor would trail the benchmark by 2% per year because of these fees.


Even if fees were not part of the equation (there are funds and ETFs available now that are 0% fee index funds), there are still reasons your performance may trail a benchmark.  The timing of the investment additions or cash withdrawals will affect the performance.  If you are dollar cost averaging and making additions to your investments each month, then the part of returns that occur later in the year have a bigger impact then the part of returns that occur earlier in the year.  The reason is that you have more money in your account being affected by the return.  Say the return for January is -3% and the return for December is +3%.  If you have been adding money along the way, you will have more invested by the time December comes around and it will help your “dollar-weighted” performance.

On the other hand, if you are in retirement and making consistent withdrawals then the sooner bad returns happen, the worse it is for you.  This is the whole idea behind sequence of return risk (see 08/02/2019 blog post).

Regardless of whether you are adding money or withdrawing it, the simple fact that you have cash flows coming in or going out will cause the returns you experience in your account to be different from the benchmark which assumes that the only additions would be from reinvested dividends or interest.

Investment Composition

A third reason your returns might not match a benchmark is that the particular investments you have don’t exactly match what is in the benchmark.  This might easily happen if a large-cap fund manager for an actively traded fund has different sector weights than the S&P 500 index (which we’ll assume is the appropriate benchmark).  Perhaps she even holds the same 500 stocks as the S&P 500 index.  She just holds them in different proportions than the index.  If she is “overweight” the good performers, her fund will outperform the benchmark (assuming her fees don’t eat up all the difference!).  On the other hand, she might have decided to be overweight in the sectors that are lagging and her fund performance will be worse than the index.  The difference that is there is the result of differences in the individual holdings in the fund compared to its benchmark.

This might also happen if one is comparing the performance for a conservative allocation fund to a conservative benchmark (like the Morningstar Conservative model portfolio).  Perhaps the conservative allocation fund manager has decided to be 24% equity and 76% fixed income as compared to the 20% equity, 80% fixed income in the benchmark.  In this case, if equities outperform fixed income, this fund will do better than its benchmark.  It will have a different composition, it will entail more risk, but it will compare favorably to its benchmark.


Yet another reason that investment performance in your account might be different from its benchmark is due to rebalancing.  Typically, a benchmark will involve systematic rebalancing to determine performance.  For the Morningstar portfolio benchmarks that we use the rebalancing occurs on a monthly basis.  If a particular investor’s account isn’t rebalanced on the same schedule, this could again create differences in performance over the course of a year.


The final reason I’ll mention in this post relates to taxes.  This is more of a stealthy reason for performance difference because taxes are rarely if ever paid out directly from the investment account.  However, if there are dividend payments or interest income or capital gains distributions that occur in a taxable account, there will be an increase in the tax amount an investor pays because of these gains.  This is effectively reducing the performance of the account compared to its benchmark where the returns reported are not affected by taxation.

For all the reasons listed, and probably a few more that aren’t listed, it is unlikely that your investment performance will match the performance of the benchmark you have chosen.  But it is important that you understand how big the difference is and what is causing the differences.  Are you being killed by fees?  Is your investment selection very different from your benchmark?

The goal at the end of the day is that your performance over time is close to and perhaps slightly lower than the performance of the benchmark.  However, ideally you would see a very high correlation between your performance and the benchmark’s performance.  That will mean that you have invested in a way consistent with your goals.

Investing Risks

By Scott Roark, MBA, PhD | June 5, 2020

In all of life, we face risk.  Some of these risks are for possibilities that are extremely remote (lightning strike, shark bite, lottery win).  And in many cases, we can effectively eliminate these risks (don’t play golf in a thunderstorm, don’t swim in the ocean with a papercut and don’t buy lottery tickets).

In the investing arena, there is risk as well.  Many people equate the stock market with risk – and there is certainly a fair amount of risk in that world.  But there is also risk involved in buying bonds (even treasury bonds!) and even in having ultra-safe holdings like money market funds or CD’s.  In the space below, I’ll briefly discuss a (non-exhaustive) list of risks that are faced by everyday investors and I’ll finish by discussing proven ways to manage these risks.

Risks Faced By Stock Investors

Without a doubt, there are sizable risks faced by investors who purchase stocks or stock funds.  Among these are the following:

  • Market risk/Macroeconomic risk – this is risk faced by all equity investors and is related to the overall market climate. If the economy moves from expansion to recession, most firms will feel the effect and have poor returns as a result.  Interest rate changes, oil price shocks and legislative changes (tax code) can have broad impacts on the economy in general and on stocks in particular.  These risks are most easily seen when most firms in the market take a drop together.
  • Industry specific risk – this is the risk that companies in a particular industry will be hurt by some factor. For instance, if the price of oil increases significantly, then industries that have fuel as a significant input will be especially hit.  If jet fuel prices increase dramatically and for a long period, the share price of airlines will likely be hurt much worse than companies in general.   These kinds of risks are most easily seen when many companies in a particular industry drop together – and they drop much more than the overall market.

Other examples of industry specific risk might be litigation risk, where lawsuits have a negative impact on the entire industry.  Think of tobacco settlements or a class action lawsuit that puts a big dent in a firm’s share price.

  • Company-specific risk – this is the risk that something will happen to an individual company that causes its price to drop, even while other companies might do well. An example might be a CEO who is arrested for embezzlement and whose company’s stock takes a dive.  The rest of the market isn’t likely to be affected by this one person’s criminal activity so the decline in the share price of this company may be quite isolated and really stand out.

Risks Faced by Bond Investors

While generally the risks faced by bond investors are lower than for stock investors, there are still sizable risks that bond investors must face.  Among the biggest risks are these three:

  • Default risk – this is the risk that the borrower will not pay some or all of what they have agreed to pay. This is largely reflected in the credit rating that a bond will have.  If it is a “junk bond” (known more generously as a “high-yield bond”), there is a higher risk of default compared to an “investment grade” bond.  The bonds with the lowest default risk are U.S. Treasury securities.

When companies go through hard times, the likelihood of default and bankruptcy goes up.  In the past month, there have been several firms that have filed for bankruptcy and whose bonds have been adversely impacted.  If you own a JC Penney bond, it is a virtual certainty that the bond won’t pay all the promised interest payments or pay back the face value of the bond upon maturity.

  • Interest rate risk – this is the risk that interest rates will change in a way that hurts the value of the bond. For most bonds, this risk is really about interest rates going up.  When that happens, the value of a typical bond goes down (bond prices and interest rates move in opposite directions).  How much the value of a bond will move based on interest rate changes is frequently estimated by looking at a bond’s “duration”.  This can be frequently found by looking at a financial website.  Bonds (or bond funds) with higher duration will be more impacted by interest rate changes.

Consider two types of bond funds – one a “short-term” bond fund (with a relatively low duration) and one an “ultra-long” bond fund (with a very high duration).  At the time this is written (in mid-May 2020), the year to date change in value of short-term bonds has been an increase of about 3.5% because interest rates have fallen this year.  However, ultra-long bond funds have gone up close to 30% over the same time frame.  If interest rates had increased by the same amount, then these bond funds would have fallen by 3.5% and 30% respectively.  Long-term bond funds are definitely not without risk!

  • Reinvestment risk – this is the risk that interest rates will decrease and when a bond matures, it will be reinvested into a bond with a lower interest rate and so interest income will decrease. This particular risk has been a persistent one over the last 10+ years – where interest rates are so low that generating income from bond holdings is increasingly difficult.

Risks Faced by Savers

Even people who save money and buy CD’s or money market funds aren’t immune from risk.  While it is true that they don’t face default risk (especially if there is FDIC insurance or government backing of money market funds), they do face one especially nasty risk:

  • Inflation Risk – this is the risk that price levels will increase over time which erodes the value and purchasing power of money. Even at a relatively low level of 2% inflation, there is a significant deterioration in purchasing power over a 30-year retirement horizon.  If inflation averaged 2% per year for 30 years, things would cost about 80% more in 2050 than they do in 2020.  And as retirees probably understand, just because overall inflation is 2% doesn’t mean that the specific goods and services you consume will have the same inflation rate.  Healthcare has had a higher inflation rate – and if healthcare inflation averages 5% for 30 years then something that costs $500 today will cost over $2,160 by 2050.

If the returns from your investments/savings aren’t keeping up with inflation, then you are losing purchasing power and you are worse off in the future – even if your account balance hasn’t gone down.

With all these risks to consider, it might be daunting to think about investing at all.  But by diversifying your holdings (spreading your investments among stocks, bonds and cash), you can mitigate these risks.  A diversified portfolio doesn’t eliminate the risks, but they are definitely reduced.  Stock values will tend to increase by more than inflation over long periods of time.  Bond holdings will tend to reduce the overall volatility of a portfolio that includes stocks.  And having some cash is always a good thing – you can use it to pay for things without having to sell holdings that may have gone down in value for the time being.