Active Vs. Passive Funds, Which Is Best?

active vs. passive fundsOn the active vs. passive funds debate, remember that the vast majority of active funds do not beat their benchmark over a long period of time (10 years plus). Therefore, the vast majority of your portfolio should be in passive funds in order to stack the odds in your favor.

In fact, an entirely passive portfolio is perfectly appropriate. Over time, the key to achieving your financial goals is how well you managed human nature — how much you saved, how well you managed emotions. The key cannot be which small-cap value fund you picked.

In practice, many active funds are just expensive, less tax-efficient index funds that are too diversified to ever beat the market. If their largest position is less than 5% of the fund, that’s a bad sign.

If you are not comfortable with a manager having 10% or more of their portfolio in one stock, stick to passive funds.

When to go active

Active funds can make sense for a small portion of your portfolio. I would prefer active funds with very low turnover and a concentrated, “best ideas” portfolio of 30 or fewer holdings.

Active management in bonds is a bad idea unless you are looking to invest in the riskiest parts of the bond market, such as high yield. The long-term advantage an active manager could gain over a high-quality bond index is negligible and a poor risk to take.

Remember, to beat the market, you must look different than the market. If you’re not comfortable with your active fund lagging the index over a multi-year period, then you should just stick to passive funds.

The active funds with the best long-term records often underperform for years at a time. Underperformance is a major risk that you eliminate by choosing passive funds.

Buffett’s view

It probably takes 20 years or more to tell whether a manager’s success was due to skill or luck. In fact, a concentrated manager could beat the market over time largely due to one position.

I would start by looking at the manager’s shareholder letters over a long period of time to see if their philosophy and process had remained consistent.

Nevertheless, Warren Buffett, the greatest investor of all time, told his trustee to invest his wife’s inheritance in index funds. What makes you think you can pick a winning active manager?