Active Versus Passive Investing

March 20, 2007

An interesting take on the active versus passive debate from Chuck Jaffe. It's not so much whether you invest in an index or an actively managed fund that matters. They best kind of fund for you is the one that will make it less likely for you to get stuck in the devastating buy high, sell low cycle:

McGuigan was concerned when he read a Morningstar Inc. report this year, showing that the average investor in index funds actually captured just 79 percent of the return that they should have gained (so if the index was up 10 percent, the typical investor gained 7.9 percent).

Indexing is designed to be a buy-and-hold strategy. Yet numerous studies show that investors in all funds tend to earn less than the fund does, because they buy in after a fund has shown big gains and sell out when a fund hits rock bottom. McGuigan was surprised to see that indexers lagged their benchmarks by so much. He figured that a rapid indexer would know better than to jump around.

His conclusion is a simple equation, one that explains the real reason why many investors are better suited to actively managed funds regardless of the cost/turnover benefits of indexing:

Real investor returns = actual investment returns +/- investor behavior.

'The second part of the equation is so important, because investors constantly hurt themselves,' says McGuigan. 'So the important thing is that investors believe in what they are doing. If they believe in passive investing, they need to believe it enough to stick with it; if they believe they can pick better managers, they need to give those managers a chance.'

So the issue is not so much active versus passive - or a mix of the two - as it is: 'Which can you stick with when the going gets rough?'

No matter which type of fund you buy, declines are inevitable. But if you can pick a good performer, active or passive, and stick with it to get the same results that the fund actually delivers on paper, that's when you'll have a portfolio that has a real chance of helping you reach your financial goals.


MAXadvisor Private Management, the fund-based financial advisory company we founded in 2002, buys both index and low-cost actively managed funds for our client portfolios - and we never, ever buy whatever fund happens to be at the top of the performance heap for the very reasons that McGuigan describes.

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Ask MAX: What's better: an index fund or an actively managed fund?