What's better for your stock portfolio — index funds or active management? The debate has carried on for decades, and index investing has become increasingly popular over the past 20 years. It's a complicated topic without an indisputable answer that applies to everyone. However, 2020 was helpful for setting context and reviewing the facts. With a crazy year behind us — and more turbulent market conditions ahead — now's a great time to review your investing strategy to make sure you're making the best decision for long-term returns.
Active management, a source of controversy
The argument in favor of indexing is straightforward and compelling. Index funds have produced simple, reliable, and sufficient growth for most investors. S&P 500 returns have been positive over almost every 10-year period in history, and even the steepest crashes have been followed by bull markets. As long as the global economy grows, indexing should result in long-term gains that far exceed what you'll get from most bond portfolios, savings accounts, money market accounts, or CDs. All of this can be delivered without the risk entailed in active strategies, and — importantly — without management fees that erode your gains year after year.
That's some pretty compelling stuff. Still, some investors will point out that indexing has flaws and shortcomings too. Passive investing will produce results that are just fine for most people. However, it will never provide returns tailored to individual goals and risk tolerance. Moreover, index funds can go only one way when stocks are falling. Market cycles are inevitable, so there will be years when passive investments lose money.
Active managers, on the other hand, can allocate to stocks that will grow faster in bull markets and decline less in bear markets. They can even directly profit from crashes by hedging with options or short positions.
Fund managers try to create value for their clients by anticipating market movements ahead of time and building a portfolio accordingly. Anyone can deliver returns when the whole market is rising — that's not the case when equities are taking a beating. Active managers often aim to take the catastrophic losses of market crashes off the table, and that's why many people still believe in them.
Active management still didn't outperform in 2020
During bear markets and volatile periods is when investment talent is supposed to shine. Sophisticated investment strategies can deliver returns in any situation. Day-to-day volatility creates opportunities for larger gains than you get in calm markets. It's harder for fund managers to justify their worth when the market is sending everyone's account higher. If active management can't clearly separate itself during tougher times, the credibility of the whole approach is threatened.
With that in mind, it bodes poorly for fund managers that most U.S. equity funds lagged the total market for full-year 2020. Studies showed that active managers were struggling to outpace indexes halfway through the year too. Even more concerning, last year was actually one of the more successful years for these investors. Fewer funds outpaced the indexes during the bull market of the past decade.
2020 was the most turbulent time for stocks since the Great Recession, and it should have been a standout year for active strategies. Instead, passive investing proponents gathered more ammo to support their stance.
Some nuance before you decide the debate is settled forever
Just because most active strategies fail to deliver superior long-term net returns, we can't assume that they're all bad. Some of them do beat the market, even if that's somewhat rare. Moreover, everyone has different goals and risk tolerance. It might make sense to dedicate a portion of your portfolio to an actively-managed fund. They might be better at minimizing risk or maximizing growth, depending on your personal circumstances.
There are also shades of gray between active and passive investing strategies. For example, you can buy ETFs that track niche indexes rather than the whole market. These could be specific geographies, stock sectors, or industries with various risk and return profiles. Examples would be growth indexes with higher upside or quality/dividend indexes optimized for stability and income rather than growth. Using this sort of strategy isn't purely passive, since you have to allocate to various niche-index funds. It might also be something you can do yourself without incurring management fees charged by professionals.
There are also “rules-based” strategies that are considered semi-passive. Factor investing, for example, doesn't rely on stock picking or market timing per se. That sort of strategy allocates to a smaller range of stocks and selects portfolio weights based on different characteristics than those used by simple index funds.
Ultimately, you have to determine your overall goals and risk appetite. The best strategy for you isn't necessarily the best for someone else, so you have to weigh the pros and cons of any investing approach as it relates to your personal financial plan. Passive and active investing strategies both have merits, and many people would even benefit from combining the two.
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