Active Versus Passive Investing: Should You Try to Beat the Market?

March 25, 2013 — -- Amateur and professional investors alike are always looking for a clear route to good returns, so they seek rules to invest by. But often, the rules aren't clear: Maxims embraced by some are rejected by others, and amid strong arguments both ways, ambiguity reigns.

And so it is with the loaded issue of whether to invest actively — by buying and selling securities or paying a professional to do this for you — or passively, by putting your money in funds that hold stocks determined by a given index, such as the S&P 500. While these so-called indexers swear by the potential of so-called passive management to smooth over bumps and reflect the market's total return, champions of active management insist that indexing can be as certain a road to ruin as it is to riches.

This debate has gone on for more than 20 years, sometimes with the same fervor as Democrats versus Republicans. My own view is that because each has advantages and disadvantages, the best route is to have some of each. This view comes from examining these strengths and weaknesses and how they affect investors year in and year out — and in the current market.

Here are some of the reasons for this view:

• Passively managed stock mutual funds – those pegged to an index (owning the same stocks as the index) -- are fine when the overall market is rising in value because these indexes tend to rise in tandem. Yet the absence of management to buy and sell stocks means there is little risk management. In a down or volatile (up-and-down) market, this can mean losses. For example, if your index is the S&P 500 and the overall market trend is down for years, you not only sustain real losses, you also get no compounded returns and you get eaten up by inflation because the buying power of what's left of your original capital is eroded.

Of course, the mere presence of management isn't necessarily a good thing, as many managers make the wrong moves. But if you can find a manager whose skill reduces your risk, it may be worth it for you to pay for his or her services to help protect you from market downturns.

• Critics of passive management often fail to consider returns relative to risk. If a passive fund returns 90 percent of the index while taking only 70 percent of the market's risk, that's pretty good. All returns must be judged in light of the risk you take to get them.

• Many actively managed mutual funds (the kind you probably own in your 401(k) plan) have trouble beating their benchmarks — achieving returns relative to some indicator reflecting the overall market. Many investors figure, if most actively managed funds can't beat the index, why not just invest in a passively managed fund pegged to the index and be done with it? Yet many people aren't aware that most passive investments — indexed mutual funds and index ETFs (exchange-traded funds) — also underperform their benchmark because of trading costs and expenses.

• Passive investors tend to embrace the concept of market efficiency — that all known information is rapidly reflected in stock prices — so that stocks tend to be valued fairly (accurately relative to market demand) and there's no real way to beat the market by investing on knowledge that others don't have. Many respected financial experts believe in market efficiency, but others have long believed that investors can benefit from what they call windows of inefficiency.

The market may ultimately be efficient, they argue, but it sometimes takes a while for significant information to be priced into stocks because it is not yet generally known or noticed. For example, because U.S. investors pay less attention to small-company international stocks than they do to domestic ones, this may reduce efficiency, allowing well-informed, quick-thinking investors to invest on positive new information ahead of the pack, buying before run-ups.

Whether you're active or passive, the key is to manage your risk. Even a naïvely assembled stock portfolio that is well diversified can gird you against damage from a sliding market, though many such investors would be better off investing in mutual funds managed by professionals with proven records of containing risk. Passive investors can build in their own risk management by buying index funds pegged to widely varying indexes.

Ed Easterling of Crestmont Research talks about two market climates: a positive climate, in which you can just set sail and let kind market winds propel your portfolio vessel in the right direction, and a difficult one that requires you to laboriously row to reach your goals. Because of the current global economy, which includes recession forecasts for Europe, I don't believe Easterling's beneficial climate is on the horizon. If you disagree, you might want to go heavy on passive investments. But if you agree with me, you should use some active investments to get where you want to go.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

Ted Schwartz, a certified financial planner, is president and chief investment officer of Capstone Investment Financial Group. He advises individual investors and endowments, and serves as the adviser to CIFG UMA accounts. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on how to achieve their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com.