ROGER MUNS

Background
Chris Foster and Judy Mims fiercely competed during medical school. Now, they are in the same medical group and are fiercely competing again — this time with their investments. Chris strongly believes that passive investing is better while Judy is convinced that active investing is the way to go. The active versus passive investing debate went on and on and neither was willing to acquiesce.

Judy suggested they have a friendly wager: annually, the one with the better total return would collect $100 from the loser. Chris agreed, knowing that investing is not a horse race, but more like a marathon. So Chris proposed another bet: after five years, and each year thereafter, the one with the best five-year returns wins $500. With as much as $600 at risk annually, they agreed to the bets and started immediately with the competition.

The following describes passive and active investing and the theoretical and empirical support for each:

Passive investing
An index is a predefined group of securities that seeks to closely track a portion of the market. For example, the Standard & Poor's 500 Index is a widely used barometer of the performance of large-capitalization U.S. stocks. Indexes track the performance of large-cap, mid-cap, small-cap, value and growth U.S. stocks; European, Pacific and emerging market stock indexes; short, intermediate and long-term bond indexes; economic sectors such as health care, utilities, financials and energy; and other segments of the market.

Securities held in an index fund are "passively" invested — simply holding most or all securities that compose the target index. Three primary advantages of index funds begin with first, low costs. Management fees of index funds are typically a small fraction of the fees for actively managed funds. Index funds do not have to pay a fund advisor to analyze and select stocks. Index fund managers infrequently buy or sell securities, which reduces trading costs. Second, competitive performance. From 1986 to 2005, equity index funds and bond index funds beat the performance of actively managed funds 66 percent and 81 percent of the time, respectively. Third, tax advantage. Because index funds typically have a much lower portfolio turnover than actively managed funds, index funds tend to realize and distribute only modest capital gains to shareholders.

Active investing
Active fund investors seek to realize higher returns even after deducting their higher fees. Three techniques used to do this are: first, security selection. Analyzing and selecting securities that will beat the market. These securities may have an intrinsic value higher than the current selling prices, a growth rate that is not reflected in the current price or other attractive prospects. Second, market timing. Over or under weighting sectors or equity and bond styles should perform better or worse than others. Third, holding a limited number of securities. By doing this, their successful holdings will have a bigger impact on the fund's returns (and vice versa). For example, the S&P 500 index is composed of 500 equity securities and an active fund manager may hold only 50 securities including a few large-cap stocks not included in the index.

Empirical evidence suggests that adding net wealth after expenses by security selection or market timing is difficult. Most securities are thoroughly analyzed by highly motivated and talented experts leaving few bargains to be found. However, some equity sectors such as small-cap U.S. stocks and international stocks are not as thoroughly researched allowing active managers a better chance of finding bargains. Also, at times investors tend to run the price of stocks up too high and down too low. A savvy active investor can seek to capture profits from these anomalies. Also, during bear markets, active investing can do better because their managers cannot find attractive investments and consequentially increase their investment in cash.

Conclusion
There is a place for passive and active investing. In taxable accounts, passive investing is more tax efficient. In bear markets, active investing may outperform. The best of the best active fund managers will frequently outperform passive funds — primarily in the less transparent sectors of the global economy. Passive investing gives you an excellent chance to get returns in line with the underlining indexes, but will not hit you home runs. Active investing can significantly under or over perform in relation to the underlining indexes — occasionally hitting some homeruns and striking out.

Who do you think will win the bets — Judy, the active investor, or Chris, the passive investor?

Next month: Hedge Funds.


July 2007