Passive investing, also known as index investing, has become a popular strategy among individual and institutional investors alike. If you are not familiar, indexing is an investment approach where investors buy a stock or bond market in its entirety, rather than attempting to select the specific investments they believe will outperform. Since the performance of an index generally represents the aggregate performance of all investments combined, indexing implies that investors have little chance to outperform the market over the long-term and are better off accepting the average while minimizing taxes and expenses.
While some of the indexing arguments indeed have merit, active investment management has tended to work better in certain areas of the market and under certain market conditions. Research has shown that an active approach works best in areas of the market that are not as widely followed by professional investors and where differentiation between investments is great.
For example, most stocks in the S&P 500 are closely followed by many highly educated and experienced stock analysts. In order to reasonably expect to outperform the S&P 500, an investor would need to consistently outsmart these analysts. However, smaller companies or those traded only in international markets are typically not as widely covered, enhancing the chances that a good investment may be overlooked by other investors.
Other conditions that have favored active management are:
- High volatility markets where active managers have more opportunities to add value.
- High interest rate environments where the lower quality companies included in many indexes struggle to perform.
- Market environments with little disparity in stock valuation. In other words, when investors are buying stocks without regard to value.
As with any investment approach, pros and cons exist for both active and passive management. Certain conditions clearly favor one or the other, but it is creating the proper balance of each at the appropriate time that is most important.