Passive vs. Active Investing – What should you do?

In his will, renowned businessman and investor Warren Buffett reportedly left instructions for his heirs to invest in index funds, based on a belief that those funds would outperform actively managed, higher-fee investment vehicles such as mutual funds, hedge funds, private equity, etc.

“A low-cost index fund is the most sensible equity investment for the great majority of investors,” Buffett asserts in his book The Little Book of Common Sense Investing.

Passively managed funds, including index funds and exchange-traded funds, or ETFs, are investment vehicles that generally carry lower fees than actively managed funds because, rather than trying to outperform the market as many active managers do, passively managed funds are designed to track the market.

Actively managed funds incur costs for research and trading in the name of outperforming the market, costs they pass on to investors. With passively managed funds, those costs are minimal or non-existent.

Passive investments may perform better than their actively managed counterparts over time, further increasing their value. Fund company Vanguard compared the 10-year records of the 25% of funds with the lowest expense ratios and the 25% with the highest expense ratios. The low-cost funds outperformed the high-cost funds in every single category.

The huge variety of passively managed funds available today gives investors the means to build a diversified investment portfolio that includes various classes of stocks, assorted types of bonds and other asset classes, such as real estate or commodities.

How to access lower-cost passive investments? They are offered as investment options within many retirement accounts, including 401(k)s as well as traditional, Roth and SEP IRAs. Investors also can purchase them for a taxable investment account.

In the case of a 401(k) or IRA, for example, an investor can execute a rollover in which they instruct their plan administrator to move assets from an actively managed fund that holds S&P 500 stocks to a similar index fund or ETF whose value is linked to the movements of the S&P 500.

As appealing as the passively managed value proposition may be, there is still a place for actively managed investments inside many investment portfolios. Costs are important, but they should not be the only factor driving decision making.

Certain actively managed funds consistently outperform the market, making them a good value despite higher fees. What’s more, an actively managed investment may be the only available option to gain access to a specific position or desired strategy. However, I would caution readers to only employ active funds if working with a financial professional – specifically a fee-only advisor.

Still, it would be a mistake to ignore the merits of ETFs, index funds and other passively managed investments. Because, as Warren Buffett and millions of other investors have discovered, over the long haul, you may be better off trying to track the market rather than trying to beat it.

JASON E. SIPERSTEIN, CFA, CFP, RMA, is the chairman of the Financial Planning Association of Rhode Island, program director for CFA Society Providence and president of Eliot Rose Wealth Management. He can be reached by email at jes@eliotrose.com.