66. Your Investment Approach: Active vs Passive
Your Investment Approach: Active vs Passive
This is probably the factor that will have the most impact over how you see investing and how you construct your portfolio. However, listen through to the end as I explain how Passive and Active shouldn't necessarily be seen as "one or the other" and more as a grid for how you see the investing world and how you implement it for yourself.
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Transcript:
Hello, and welcome back to the Canadian Money Roadmap Podcast. I'm your host, Evan Neufeld.
Today is the next episode in our Building Your Own Investment Approach series, and we're taking a look at active vs passive.
The active versus passive debate is one that rages constantly online and in the advisor community. And this is kind of a big one here in, in terms of establishing your own investment approach and what you prefer in terms of philosophy. The problem with the debate is that it's largely become devoid of any nuance. You know, if you're looking in the DIY investing community, it's “active is bad, passive is good”, and there's also people that are firmly in the “active is the only way to invest because passive is dangerous”, you know, that kind of thing. I would say there's probably more to the story and this podcast, my goal here, of course, is to just show what active and passive are, and you can kind of decide what you prefer from there,
One thing that I want to get out of the way first is that although I am an investment advisor and a financial planner, so part of my business is implementing investment portfolios for people. However, as an independent advisor, meaning at my dealer here, we don't have any specific products like a bank might or some other investment firms would offer their own products. Since we're independent, my compensation isn't tied to a single strategy at all, and so I hope it doesn't come across that I'm leaning one way or another because of how I'm compensated as an investment advisor because there's a prevailing thought out there that financial advisors are compensated to sell high fee active mutual funds. Maybe some of them might be out there, but just speaking for myself here and many other independent advisors, but my compensation is the same whether using mutual funds, ETF, active, passive, strategic or tactical, you know, all those kinds of things. Yeah, so I wanted to get that out of the way that I hope there isn't a conflict of interest in how I'm presenting this. For my case in particular, for others I can't speak for them, but that's the situation for me.
So first let's talk about passive investing. So passive is the idea that you own a broad set of investments, and it owns a little bit of everything. In theory you own the good, you own the bad, then your return is kind of the average between it all. So when we talk about the market and how the market performs, passive investing tries to replicate that. So this is the idea of index investing. So you might have heard of index funds, I've talked about that a few times in the series here. Index investing, passive investing, they kind of go hand in hand. I think there's a bit of an obsession with passive investing these days because passive sounds like money for nothing, meaning there's less risk or things like that. I would argue that is definitely not the case. And passive is just the idea that you're not necessarily picking and choosing the individual components of your investment portfolio.
So active investing on the other side tries to provide a different outcome either by improving returns, so this is the idea of hopefully beating the market, right? So if passive investing just tries to own the whole market, active tries to say like, okay, well we can beat the market. And another potential outcome for active investing is potentially decreasing volatility or both in some cases. Okay, so this is usually done by picking stocks and bonds. Either you could do that personally. So if you have an active approach yourself and you want to actually pick and choose your own stocks, that would be an active philosophy. But mutual funds or ETFs are really common ways that an active investment philosophies implemented. The idea with active management is that you can hopefully pick the good stocks and ignore the bad.
I've mentioned mutual funds and ETFs here already, but I just wanted to hop in here and interject and say that passive investing does not equal ETFs and active investing does not equal mutual funds. That is objectively false. I've talked about that on a couple episodes before, but ETFs and mutual funds are just structures for pooled investments, and they can either be passive or active. I won't go into the benefits of the pros and cons of each. It's not the main conversation today, but just be aware that ETFs and mutual funds are just types of pooled investments, and they don't speak to the investment strategy at all. There are active ETFs and there's passive mutual funds. We're just going to talk about the strategy and not the tool itself.
So why would you want either passive or an active approach? Well, passive approach is easy to understand. We're just buying everything. It's easy to track and it's low cost. So it's easy to track, meaning if you take a look at a headline, you say like, okay, well this is what the TSX 60 did today. They will give you functionally the returns and the investment experience in the news. So it's, really easy to kind of pay attention and say like, okay, well I know what my portfolio did. And it's really low cost because implementing a passive approach can largely be done by computers. And so there's fewer people involved and there's no analysis to do, it is very systematic. So you can keep the cost low and over time the average or the market return has actually been quite strong. And so just investing in everything, meaning getting the market's return is a fantastic way to meet your investing goals. And so needing to beat the market. Is something that many investors have, set aside and said like, well, I don't really need to because investing in equities, I can get a great rate of return over a long period of time by just owning the market.
Now, on the other side, an active approach is appealing because there's an opportunity to beat the market and have higher returns yet. But I don't think that the people that take this approach are necessarily greedy or anything like that. In my opinion, I see active investors seeing their approach as prudence. The idea with an active approach is that there are companies that are worth investing in and some that aren't. And avoiding those that aren't worth investing in is a prudent exercise. The idea there that the ones that aren't worth investing in will maybe go to zero or not have outsized returns. And so an active investor wants to beat the market and has a goal of doing that through the idea of in investing prudence.
Now, the other side of the coin, why wouldn't you want to invest in active or passive? This isn't going to be an exhaustive list here, but to stay with active right now, active investing is incredibly difficult to do, is incredibly difficult, and it's more expensive and it takes more time. So being able to pick stocks and specifically pick the companies that will outperform in the future is way, way more difficult than it might seem at the surface. And as a whole, the professionals that try to do this have an incredibly difficult time doing it on an ongoing basis over a long period of time, if you're going to be the one that picks the individual stocks in your own portfolio, so you're not using funds or ETFs. If you think you can do it, I would wish you well, because professional investment managers with armies of analysts and data and software meeting with the companies directly, they have an incredibly difficult time beating their index over a long period. So let me talk about that for a second. So the s&p, so that's standard and poors. It's a rating agency. It's not just the s and p 500, but s and p puts out a report every year, it's called SPIVA, which stands for s and p Index versus Active report. They do this every year. They do it a couple times a year, actually it's pretty cool to take a look at. They will evaluate a variety of metrics for different countries and things like that to see how investment funds have done relative to their index. Keeping in mind that you can't invest specifically in an index. An index fund gets you close, but there's cost associated with an index fund that the pure index won't account for. So anyways, just that little caveat there. But the SPIVA report looks at how many investment funds outperform their index over time. Let's keep it simple. There Are many pages of documents here, but just looking at Canadian equity funds, so those will invest primarily in Canadian stocks and they are located in Canada. Okay, so just looking at Canadian equity funds for Canadians as of the middle of last year. So I only have data going into the middle of 2022. At that point, 57% of active funds beat their index. Oh, okay. That's pretty great. 57%, so it's better than a coin flip. However, as time goes on, the SPIVA report looks at not just year to date, but it looks at one year, three or five 10, and so on. As time goes on, it gets more challenging. So on a 10 year basis, only 18% of professionally managed investment funds beat their index. In this category, it's definitely not zero, but it's much worse than a coin toss. And so there's different types of funds, so like US equity funds that are actually even worse, but small cap Canadian equity funds are a little bit better. So anyways, I just wanted to give one number here. So on a year to year basis, it's much more possible to beat the index over a short period of time, but as time goes on, it gets tougher and tougher and tougher. And yeah, in this case, again, 57% were beating on a year-to-date basis, but as time went on over a 10-year basis, only 18% beat. So that is extremely difficult to do over a long period of time. So fees play part here because even if a manager can beat their index over time, the fees that they have to incur to do it might reduce the return to the point where they didn't end up beating at all.
So that's the main reason that you probably wouldn't want to invest in an active fund is that it's incredibly difficult to beat the index. You might say like, okay, well 18% over a 10 year period of time, you know, that's still a decent number. The challenge is knowing which ones will outperform over a period of time in advance to be there when they do it. So it's not that it's impossible. It's not that someone who's invested in active funds hasn't had a good investment experience. It's that knowing what's going to happen over the next 10 years and being with the right managers at the right time is really difficult to do. Now, on the passive side, why would you not want to do a passive approach?
Well, if you like to make choices, if you don't like the idea of just getting average, if you want to try to outperform, bless you, you can try. If you want to invest in a specific way, so by avoiding certain industries or specific companies in particular. So you might take a look at the, let's say the s and p 500 and you say, well, I don't really like Meta or Facebook, and they would be in the top 15, I think in the s and p 500. It's like, okay, well if you own an s and p 500 or a US Index fund, you're going to own that company. Even ESG investing, so if you want to focus on companies that are more environmentally conscious , yes, you can do it through an ETF, yes, you can do it through a mutual fund. Yeah, you can do it your own way by picking and choosing stocks, but that is more of an active approach. So an ESG fund, I believe, is inherently active in that there is an active choice being made of which companies to exclude from the investment. So a truly passive approach just says, well, I don't care what's out there, I'm going to get the whole market. But if you like to make some choices yourself, if you'd like to have fun and picking some stocks, sure. If you don't like the idea of just getting average and you want to try, an active approach might be good for you. And if you want to invest in a specific way, that's probably some of the main reasons why you wouldn't want to go with A full passive approach.
However, if we go back to the odds of beating your index over a long period of time, let's say you don't like those odds stacked against you, say you'd rather pick a passive option. Let me play devil's advocate and show you how that's probably not as straightforward as you'd expect. Okay? So even when investing with a passive philosophy, active choices are required. Things like your geographic allocations. So if you're going to go with a passive approach and you read a book that says that you should buy the s and p 500, well why are you specifically excluding companies that are based in Canada, or based in Europe, or based in Asia? If you're just going with that approach, you're making an active decision to exclude certain parts of the market. And if you look over the last 21 years, the US has been the top performing market only once in the last 21 years. So are there opportunities left on the table by going with that approach? Maybe. Right. So I won't get into that too much, but that is an act of choice.
Rebalance timing. So if you're owning multiple index funds to put together a whole portfolio, maybe globally diversified, like I would argue, there's benefits too. When do you rebalance, that makes a difference. Are you doing it based on your gut feeling? Oh, this one's doing well, this one's doing bad. We got to get more money over here. That starts to look a little bit more like an active philosophy, even though you're using passive tools. Which investment provider are you going to use, even if you're going with a passive option? There's lots and lots of different providers and they'll have different fees. They'll have all sorts of different approaches. Some might use an active approach behind the scenes, or they'll actually vote on things as shareholders and others will not.
Tons of different things that will come into play when selecting an investment provider. Along with that comes asset allocation. So if you're going to do a tactical approach, you're making active choices. But even with a strategic approach, so again, going back to last week, if you want to keep kind of a consistent stock and bond mix, let's say you want to be a hundred percent stocks, even within there, there's an active choice to be made at the beginning.
Okay? So let's take a look. A couple of funds, one that I mentioned a couple episodes ago from Vanguard. It's called VEQT and is a globally diversified portfolio that owns a number of index funds within it. So we call them asset allocation ETFs and they will invest in some in the us, some in Canada, some internationally, but this one won't have any bonds in it.
Now, I'll compare that to another ETF that's very similar from BlackRock. It's called the iShares Core Equity ETF, so that's XEQT. They're both trying to do the same thing. They're globally diversified asset allocation, all stock ETFs. However, if you look at their performance, they're not necessarily the same. They're not too far off, but they're not the same even on a one year period. In the last three months, even, for example, one of them, I'm not even going to tell you which one is which here, but they are different. So one of them is different by almost 0.6% over the last three months and that's not a difference at fees. The fees are almost identical. The main thing that's different between the two is their asset allocation. So one of them owns more Canada than the other one. And so Vanguard one for example, owns pretty close to 30% in Canada, whereas the iShares one from BlackRock is about 25. These differences matter, right? So that's an active choice by Vanguard and BlackRock to provide different weightings within their portfolio. And so when you choose which one is which, I would encourage you to not go back and forth between the two because that's also a risk like, oh well this one did better recently. I should go over there because it's better. No, it's just different and you just have to understand that even though this is a passive philosophy, there's active decisions that are happening behind the scenes. Probably not changing a lot, but I would argue that is slightly more than t the passive option that you're probably. So even index constructors, so the ones that are behind the scenes, let's use the s and p 500, again, so s&p is constructing that index, not just on the basis of which ones are the biggest. There is a committee that selects which companies are part of that index, and they use a number of factors. So when they consider the eligibility of a new addition, they take a look at market capitalization, liquidity, the public float which is how many shares are available to be bought and sold by the public. There's a number of other categories here that are a little bit more esoteric, but the financial viability of the firm, the length of time that has been publicly traded, all these sorts of things are active decisions that are happening within that index. One of the most interesting ones is something that changed in 2017, so that companies with a dual share class aren't added to the index. So that means, so Alphabet, that's the parent company of Google. They have a dual share class and they're part of the s and p 500, but if they were new today, they would not be part of it due to that one rule. Then there's different rules to remove a company from the index. Those ones aren't necessarily ones where if a company's in violation of any of those, they get removed. There's different criteria again. So yes, even within selecting an index fund, there is an active choice that's happening there. I'm not trying to make you concerned about that or anything, or that you need to be more involved with it. Know that even if you're selecting a passive investment approach, there's lots of active choices that come along with it.
So knowing that, now, I would encourage you to view active versus passive on a grid instead of a binary of one or the other. So on one side of this grid, there'd be philosophy, and on the other side there'd be implementation. So you can have an active or passive philosophy with an active or passive implementation.
My argument is nothing that's completely passive, but you can get pretty close, I guess. But let's find yourself on different points on this grid. So if you have an active philosophy with an active implementation, that means that you're picking stocks and bonds yourself, or you are picking and choosing actively managed mutual funds and switching back and forth between them all the.
I would argue that this is probably the least likely way to succeed over the long term because it introduces so much opportunity for human error and number of biases that can lead to underperformance over time. Probably don't want to live in this world here. And the next one, if you have an active philosophy, but a passive implementation, that would be the use of a mutual fund or an ETF or a portfolio manager to pick stocks for you, but let them do the work. So it's an active philosophy, but a passive implementation on your part, which means that you're putting the money in there. And then behind the scenes, that manager, that ETF, that if you even use a quantitative strategy, whatever they would be making those changes on your behalf. But you don't really want to be actively managing active managers. You want to sit back and let them do the work. If you have that.
Next if you have a passive philosophy, but active implementation that's more like factor investing. So there's a great opportunity to outperform here and to do very well with an investment strategy that follows this approach. Depending on how you see it, asset allocation funds, so like those ones that I mentioned from Vanguard or BlackRock they could fit in here too.
And finally, a passive philosophy with a passive implementation. This is as passive as it gets. My idea of this would probably owning a total world market fund where you'll own everything in the same ratio based on how large the companies are, we call that weighted by market cap. So market cap weighted total market fund is probably about as passive as it can get. Just owning one. You never make a decision of one place to invest or another, you just put everything in there. I have never seen a portfolio that looks like this, never once. Anytime I work with a new client or if someone sends a question or something, there's always, always some sort of penny stocks or some crypto or sector funds or some treat of the week garbage in there. There's always something, sorry, no one lives in this quadrant. you might think you do, but I've never seen it. So if, if you are like this and you're willing to share it, please send me an email. But I would probably assume that most people have A version of either an active philosophy or an active implementation within their portfolio at some level.
Okay. But anyways, seeing active and passive on a grid instead of a binary one or the other, makes a lot of sense to me. One of the last things I want to talk about here is risk. And regardless of which option you pick, you will still be exposed to investment risk. So active and passive is not related to the specific risk of that investment. I've seen it way too many times. Online, forums, listener emails, new clients even. I've seen it way too many times where people are convinced to buy index funds because it's passive income and you'll be set for life. And they aren't told that when the market goes down, that means index funds go down too. They say, oh, well, all my investments are down, but I bought index funds. Please hear me that risk is definitely present here. Because you are investing in stocks, it has nothing to do with the strategy itself. Yes, it's largely diversified, and it's not like just owning one stock, but if the market goes down, that means index funds go down too. Risk is a much more nuanced conversation, but just know that either active or passive investment strategies involve risk and the potential for losing money. I think of it kind of like a swimming pool. It doesn't matter what the shape of your pool is or how big it is or how deep it is, there's still a risk of getting seriously hurt or drowning in a pool because the risk is in the pool itself, not necessarily in the type of pool it is, or the shape or the color or anything like that. The risk is in the pool. And so in this case, investing in stocks is the risk. Passively investing in stocks or actively investing in stocks presents other types of risk, but there is still investment risk associated with that. So don't hear me saying that one approach is necessarily riskier than the other.
So let's summarize quickly here. So instead of thinking about active as bad and passive as good, or vice versa, there's a few more thoughts here that I hope I've been able to share that active has value, but it can be incredibly hard to do well. Picking the quality active managers that do outperform in advance is also incredibly hard. But if you want to have that kind of approach, It's not completely impossible, but the odds likely aren't in your favor. And on the other side of the coin, passive is probably more active than you think. And even in your own portfolio, give yourself a hard look and take a look at your portfolio and if you think you're a hard liner passive investor, maybe take a look at all those little stock holdings that you have elsewhere and see if that's really the approach that you want to take. But I'm not here to shame anybody's decisions one way or the other. It's my opinion that most people should probably follow a an index or a passive investment strategy because some of the other approaches are simply too difficult or they're more involved, or they're more complicated or more expensive. So for most people, going with a passive approach is probably a really good option, and that's even if you use a financial planner or an investment advisor. Using passive tools within a portfolio can be a great way to get great exposure to the equity market and decrease your overall investment cost.
But if you liked an episode like this and you're listening for the first time, please click follow and you'll hopefully hear a few more episodes in this series to help you determine a great investment approach that that works for you. Thanks again for listening, and I'll catch you on the next episode.
Thanks for listening to this episode of the Canadian Money Roadmap Podcast. Any rates of return or investments discussed are historical or hypothetical and are intended to be used for educational purposes only. You should always consult with your financial, legal, and tax advisors before making changes to your financial plan. Evan Neufeld is a Certified Financial Planner and Registered Investment Fund advisor. Mutual funds and ETFs are provided by Sterling Mutuals Inc.