Passive vs Active Investing

The case for 'passive' investing continues to strengthen and increase in popularity - particularly among the younger generation.

Today, one of the UK's most high-profile stockpickers, Neil Wooford, has suspended trading in his largest fund as rising numbers of investors ask for their money back.

The argument is clear: Why pay fund managers high fees to research and pick stocks when on average they tend to underperform the index? Why not just get a supercheap index tracker that is statistically more likely to compound your returns over the long term?

This compliments the old 'dartboard theory': "A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts."

It doesn't look great for active fund managers. The rate of passive investing has doubled to almost half of the US market since 2007. This trend should continue as younger people get older and start to earn and invest more.

You do have to ask, though, is this really how capitalism works? Instead of paying attention to the inner workings of a company, you just buy it because it has a large enough market capitalisation to be in the S&P 500 or the FTSE 100?

Market cap is literally the share price of a company multiplied by the number of shares it has in issue. If everyone were a passive investor, wouldn't the indices' holdings then stay the same regardless of the underlying fundamentals? What if a few of those companies started making huge losses? The only choice a passive investor makes is to be in the overall index or not - they do not discriminate on the individual constituents.

The way capitalism is supposed to work for investors is that you are rewarded over time for buying good companies at good prices and you are punished for doing the opposite. In turn, this allocates capital to more productive companies and vice versa. Therefore, the passive market must be relying on the active market - otherwise there would be no real mechanism to ensure the S&P 500 is filled with quality companies that deserve to be there.

Surely then, the growth of passive investing will make stock prices less efficient and therefore create more opportunities for the right active management styles to exploit the eventual pricing anomalies?

The problem, however, is that not enough active fund managers really try to pick good quality businesses - or at least they don't know how because they get distracted by all of the other less important data at their disposal. It's also worth noting that a lot of so-called 'active fund managers' are just glorified index huggers with higher fees than ETFs.

It is incredible how few fund managers actually try to invest like Warren Buffett: Arguably the most successful stock market investor of all time and one of the world's wealthiest individuals.

When Buffett was asked this question many years ago, he answered as follows:

Fortunately, there are a couple of active fund managers who really do emulate Warren Buffett's straightforward business approach to investing. And the results appear to be working very well so far. You can read more about them here.