SMI on the Radio: The Pros and Cons of Passive Funds and Active Funds (audio and transcript)

Aug 1, 2019
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More and more investors are choosing passive funds over active funds.

SMI executive editor Mark Biller explained both the upside and downside of that approach last week on Moody Radio’s MoneyWise Live. Mark also answered caller questions.

To listen, click the play button below — or, if you prefer, scroll down for a transcript. (For more radio appearances by members of the SMI team, visit our Resources page.)

MoneyWise Live, with hosts Rob West and Steve Moore, airs daily at 4:00 p.m. ET/3:00 CT.

To ask a question on a future program, call 1-800-525-7000 and mention you have a question for either Mark Biller or Matt Bell of Sound Mind Investing.


Steve Moore: Mutual fund investors have two main options, passive funds that are simply pegged to market indexes and funds that are actively managed by human beings. So where should you put your money? Well, we’ll explore that question first today as Kingdom Advisors President Rob West gets the inside scoop from investing expert, Mark Biller on MoneyWise Live.

Well, Rob, Mark Biller is not just another pretty face as executive editor at Sound Mind Investing one of our favorite places for biblically based investing advice. He really has to stay on top of what the market’s doing.

Rob West: That’s exactly right, Steve. And we’re always grateful for Sound Mind Investing, and for the fact that the team loans him out to us once a month. Mark, welcome back to MoneyWise Live.

Mark Biller: Thanks, guys. Good to be here.

Rob West: This is a fascinating topic, one that’s gotten a lot more attention as of late, Mark — this whole idea of active versus passive management. I’d love for you to begin for the benefit of our listeners of defining these two types of investing.

Mark Biller: When we talk about active management, we’re really just talking about a strategy or a product, like a mutual fund that has a human manager who’s trying to make investment decisions that are going to improve the performance. Now, in contrast to that, index funds are called "passive" investments because they’re just trying to replicate the performance of a particular market index like the S&P 500, for example.

Rob West: Describe these indexes for us or at least one or two of them.

Mark Biller: Yeah, sure. There’s so many different ones — and these days there’s an index for anything you want to measure. But as far as what most people are concerned with, like in your 401(k) plan, the typical plan is going to have some kind of a large-company stock index like the S&P 500 that’s probably going to have some kind of a small-company stock index, which could be a Russell 2000 or there are some other ones with various names. And then it probably would have a foreign-stock index like EAFE — again, there are several different varieties. But again, all we’re talking about here, Rob, are different slices of the market: large, small, foreign, value, growth — that kind of thing.

Rob West: And they either meet the criteria to be in the index or they do not. It’s not somebody in the background trying to determine whether or not they’re worthy of being in it. It’s just based on either their size or market sector. And that’s why these active management portfolios with real people picking stocks are more expensive than the passive ones, which can be handled by a computer. So just generally, Mark, what are the pros and cons of each approach?

Mark Biller: The big differentiator between the two is cost. Everything else really is going to flow from that. So like you just alluded to, index funds tend to be significantly less expensive because there’s no manager to pay. There’s no research staff, none of that. Whereas actively managed funds tend to be more expensive — and that means that an active investment has to outperform an index by the amount of those extra expenses just to break even with the index. So it’s kind of starting behind and has to earn a little bit more just to break even.

To take an extreme example, Fidelity recently cut the expense ratio on a few of their index funds to zero — no expenses at all. So an actively managed fund that charges 1% it has to outperform the investments of that index fund by 1% — the amount of its expenses — just to break even. That’s a pretty high hurdle. And so it makes sense why the big pro of index funds is they’re cheap. The big negative of active management is the higher expenses make it harder for it to outperform. Of course, on the flip side, index funds can’t outperform. They’re just riding along with the market. So at least active management gives you the possibility to perform better.

Rob West: The active managers, the cost is higher — so they do have to outperform to justify the added expense, but they can. And basically, the idea behind active management is you’re investing with a particular money manager, or a team of money managers, that has a unique expertise either in picking stocks of a certain sector or just in evaluating companies that are going to outperform over the long haul.

Mark Biller: That’s right. So you know you’re at least getting the chance to outperform. Now, the downside and the criticism of active management really is that whenever you look at studies that compare the average actively managed fund in a particular market segment against the appropriate index, the index almost always beats that average fund. So to be really clear for listeners here, if you don’t have a specific reason to think that you can do better than picking the average fund, then you probably would be better off sticking with index funds. If you’re trying to do this on your own without help, generally keeping it simple with index funds like in your 401k is the best way to go. That said, most of our business at SMI is based on active management, so obviously we do believe that there are ways to do better than these averages — and for most of our 30-year history, that’s been the case with our strategies.

But the reason we wrote this article and the reason we’re talking about this today, Rob, is that during this recent 10-year bull market that we’ve been in, active management has really underperformed indexing by quite a significant margin. And all of that poor relative performance has contributed to a lot of investors leaving active management and shifting over to indexing. One of the most jarring statistics that I’ve seen in a long time is that when this bull market began in 2009 the split of all U.S. stock investments was roughly 75% active and 25% in indexing, but this year that split is going to go over 50% to indexing for the first time. More than half of all U.S. equity investments will be indexed at some point this year — if these statistics hold the way they’ve been going. And that’s a huge shift in a really short period of time. The other thing that that says to us is there a lot of new indexers out there, a lot of people who’ve never written this indexing trains through a bear market before.

Rob West: Yeah, I was traveling earlier this week. I was actually at a conference of those investing in what is called impact investing, which are investments that have a kingdom purpose in addition to a financial return. And I ran into a good friend who’s an active money manager, manages a very large mutual fund here in the United States. And he was talking about this underperformance and he was expressing his frustration frankly about everything he does, buying companies that are on sale that have improving fundamentals, and that not working this year because so much of the gains in the market has been concentrated into a small number of stocks, which happened to be the ones that make up the largest portion of these indexes. You think that’s part of this underperformance we’re seeing?

Mark Biller: Oh, it’s a huge part. And there’s a self-reinforcing aspect to that as well — that the most of the market indexes are weighted to the very largest stocks. So as those perform well the indexes go up, which creates more money coming into the indexes because the performance is good. So people chase that performance. And now there’s more money being allocated to those biggest stocks, which makes the indexes go up — and you kind of get the idea of what I’m saying. Now, that’s a virtuous cycle on the upside when the market is rising.

But the part that these new indexers that I was just talking about have never experienced is that cycle can reverse and go the other way. So when the market starts falling, the same thing happens. So these largest stocks are disproportionately hit. The indexes, like we’ve mentioned before, these are computer-driven — so there’s no one saying, "You know, I don’t really think we should sell that stock." The index fund is just going to be dumping that stock so you can kind of get the vicious cycle going on the downside. So it’s, I guess to sum all that up, Rob, I would just say that indexers need to be careful because as fun as the ascent has been over these last 10 years, indexing during a bear market is no fun at all because there’s no downside protection.

Steve Moore: Gentlemen, we have some calls. Let’s go to North Ridgeville, Ohio. Steve, you have a question about index funds, Huh?

Caller: Yeah, I do. Thanks, guys, for taking my call. I appreciate your show. Just wondering how like a novice like me would get into an index investment. What do I do?

Mark Biller: Sure. So the probably the most common way, Steve, that this happens is if you have some kind of a company retirement plan, it’s very common within a 401(k) or a 403(b), whatever your plan might be, that some of the investment options are going to be big index funds. Like we talked about earlier, you might have an S&P 500 index fund or some kind of a large company stock fund in your 401(k). So that’s one easy way to do it.

Now, if you’re investing on your own, say through an IRA or a taxable account and you wanted to invest in an index fund, almost every investment company out there these days that manages money, uh, or has mutual funds I should say, has index funds. Vanguard is definitely the industry leader, but Fidelity, Schwab, TD Ameritrade, all these companies have an assortment of index funds that you can buy as well. And you’re basically just buying usually a mutual fund or an exchange-traded fund. And that is a single investment that owns all of these stocks that make up the index. So you’re just buying, usually, a mutual fund or a, an assortment of mutual funds and that gives you your index portfolio.

Steve Moore: Yeah. Mark, if Steve doesn’t have an employer who offers any sort of program or plan, then just as an average guy, what’s the quickest, best way to go ahead and find and purchase a mutual fund?

Mark Biller: Yeah. If I wanted an index fund outside of a company retirement plan and I didn’t already have an account with Fidelity or Schwab or one of those guys, then I would just go to Vanguard’s website because Vanguard is kind of the leader in indexing and I would look for an index fund that matches what I need from Vanguard’s site. Now, if I already had a Fidelity or Schwab account, I could just buy an index fund from Fidelity or Schwab through that account.

Rob West: Mark, what is your feeling on the latest introduction of the "fintech" space with so many of these computer-driven robo-advisor strategies where you answer some questions that you then have a portfolio built for you at low cost, it’s rebalanced — of course, it can be very well diversified at the same time even providing some of that downside protection. Do you like that for somebody who’s just getting started?

Mark Biller: Yeah, and I think it’s particularly helpful maybe for the real small investor who really truly is just getting started. You know, you’re going to have the same negatives I guess, of indexing where you’re, you’re pretty vulnerable. But again, as a newer investor, generally that probably isn’t going to be as big a deal as an older investor who already has a portfolio that they need to have a little bit more significant protection on. So just be careful because they do vary from place to place. Some of them are pretty good, some of them maybe not. So just make sure you understand what you’re getting into. If you use one of those robo-advisors

Steve Moore: Mark Biller from Sound Mind Investing with us for the first half of today’s program, taking your investing-related calls and questions at 800-525-7000. Steve in Chicago, what’s your concern or question, sir?

Caller: Hello, I have a question. There’s a group of gentlemen that I work with that are all invested in the Iraqi dinar and the Vietnamese dong, and they’re saying, these are going to revalue. And I was wondering, is this a sound investment or is this like a bad move?

Rob West: Yeah, Mark, foreign currency. What do you think?

Mark Biller: Oh, man. Well, Steve, you know the general principle — first of all, to be honest, I don’t know that those specific currencies — but here’s the general thing that I would, would definitely apply here: The more specialized and investment, and I think when you’re talking about specific foreign currencies, this definitely applies. you have to assume that the people that you would be trading against are probably specific experts in those specialized investments. So the more specialized you’re getting, the more I think you have to kind of think about "Who’s on the other side of the trade that I’m making?" Because you’re not going to have just some uninformed guy taking the other side of that trade. You’re probably trading against the currency specialist. So I would be very careful, Steve, because you really need to have a reason to expect that you’re going to know more about that investment than the person on the other side of that trade. And in most cases, for most of us, that’s just not going to be the case when it comes to currencies.

Rob West: Let’s go to Matt in Chicago. How can we help you, sir?

Caller: Hi, thanks for taking my call. Love your program. Um, I have some mutual funds. One of them is a foreign growth fund — mostly in China. That’s taken a hit — a lot in — the last couple of years. And I wanted to sell it, but the big issue is I’ve never sold it before, but there are disposition fees for these and then if I go and put it into another one, there’s a load. So then I think to myself, well, "Am I actually shooting myself in the foot by selling it?"

Rob West: Mark, your thoughts on that?

Mark Biller: Yeah, it does make it quite a bit more complicated, Matt, when you’re evaluating load funds that come with sales charges and fees to sell and to buy new ones. Is that through an advisor relationship that you have? Matt?

Caller: These are fairly old. I’ve had them for like 10 years and I have a Schwab account, so these kinda rolled in from an IRA a long time ago.

Mark Biller: Okay. My advice with that, Matt, would probably be if you are now taking control of that account and of the decisions that are being made in that account, I would kind of view it as a one time cost of clearing the old stuff out of your account to pay whatever fees you have to to sell the old load funds. But when you are evaluating what new investments to buy, I would limit your selection to no-load mutual funds because there are many, many good funds that don’t charge any loads or sales commissions. Generally, you only get into sales commissions when you’re working with an advisor and that’s how they’re being compensated. So if you’re no longer working with an advisor, I would stay away from the load funds and focus on no-load funds when you’re buying new replacement funds.

Steve Moore: Matt, we’re glad you called. Hope that helps you. Thanks very much. Let’s see if we can squeeze in one more. Indianapolis. Uh, yes, we have another Steve with us today. What’s your question today? How can we help you?

Caller: Um, my question may have just been answered, but is there a difference or the likelihood of having a sales load between the two, between the active and the passive?

Mark Biller: Yeah, Steve, it’s pretty unusual for index funds to carry loads, not impossible, but usually unlikely. You know, overall there’s been a move away from loads as most advisory relationships have kind of shifted over time from the old commission-based models to more of the fee-based models where you’re working with an advisor and there may be charging 1% of the total balance. It used to be that most brokers made their money from buying and selling funds. Now you can usually find good funds with no loads, even if you’re working with an advisor.

Rob West: Really good stuff today, we’ve just scratched the surface, folks. I really encourage you to go check this article. It’s Mark, so glad to have you with us today. Thank you, my friend.

Mark Biller: Thanks, guys.

Steve Moore: Thanks very much. God bless you, sir. Again, sound mind check them out today. They do great work. It’s where you can pick up a copy of The Sound Mind Investing Handbook if you’d like as well:

Written by

Joseph Slife

Joseph Slife

Joseph Slife has been a news writer for the Associated Press, a college instructor, and a radio host. He and his wife Joye have three grown sons.

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