The proactive strategy behind passive investing

Key takeaways

• Passive and active investing strategies both require proactive planning while differing in their end goals.
• Passive investing seeks to match market returns, typically by way of index or exchange traded funds that closely mirror a market. Passive funds cost significantly less on average and often perform better in more efficient asset classes like U.S. Large Cap stocks.
• Active investing aims to beat the market by selecting the specific securities you or a manager believe will outperform relative to their peers. Active funds cost 10x more on average, but tend to perform better in less efficient classes such as U.S. core bonds.
• Many institutional investors—Betterment included—employ a mix of both strategies.

Of all the confusing ‘this or that’s’ of investing, few are more misleading than the choice between ‘active’ and ‘passive’ strategies. Passive sounds hands-off—but in practice, it’s anything but.

Take our automated investing offering. While it uses a blend of both strategies, it falls more on the passive end of the spectrum. Yet on any given trading day, we’re …

• Scanning for tax loss harvesting opportunities by the minute
• Executing thousands of trades to keep customers’ portfolios humming
• Researching dozens of new funds, slotting in new options quarterly to improve our portfolios’ desired exposures at lower cost

And every year, we refresh the asset weights of all our portfolios, making sure they align with the latest global market environment and long-term projections.

Pretty lively for a passive strategy, no?

So if passive investing is a bit of a misnomer, what exactly sets it apart from more "active" approaches? And which situations are each best suited for? For those helpful distinctions, let’s start with their respective mission statements.

Two missions, two mindsets

Both passive and active investing involve someone, sometimes a “retail” investor such as yourself, sometimes a single professional or an entire firm, making decisions on what to invest in.

The key difference boils down to their objectives and related costs:

• With active investing, you're aiming to beat the market by selecting the specific securities you believe will outperform their peers. While the costs of actively-managed funds are trending downward, they’re still 10x more expensive on average than that of their passively-indexed peers.
• With passive investing, you're seeking to simply match a market’s returns. A lower bar, for sure, but also at a lower cost. The fees or “expense ratios” charged by passive funds often fall below 0.10%.

Which is better? Well, beating the market is easier said than done, especially in the long run. Consider the S&P 500, for example, the most popular pick in the market for U.S. Large Cap stocks. Fewer than 15% of similar actively-managed funds have outperformed it for stretches of five years or longer.

But that doesn't mean there’s no role to play for active investing, even for the long-term, risk-averse investor. Some markets aren't as accurately priced or “efficient” as the S&P. With the right expertise and right access to information, there’s relatively more value to be had in smaller markets like those in developing countries, and even more so in bond markets.

The question then becomes, who’s the best at sniffing out those deals? When investing in an actively-managed fund, you’re investing in the team behind it as much as the securities themselves. Conducting due diligence on the team and their track record is critical. That’s why when using these types of ETFs in our portfolios, we use a robust quantitative and qualitative research approach to size up the teams behind them.

There’s also the matter of niche markets, and whether a passive index fund is even available. One such example is the Academy Veteran Bond ETF (VETZ), one of the newest actively-managed funds we’ve brought on board. VETZ mainly invests in loans to active and retired U.S. service members and the survivors of fallen veterans, making it ideal for both active management and our Socially Responsible Investing’s Social Impact portfolio.

Lastly, a lot of everyday investors simply enjoy directing some portion of their investing themselves. When we surveyed Betterment customers about their overall investing habits, ¾ of them said they mix in some self-directed investing alongside their managed portfolios.

There’s nothing wrong with a little responsible fun like this. Picking your own securities—even alongside a managed portfolio—can be exciting and educational. And all that choice naturally leads to the next big difference between active and passive investing.

The building blocks of a portfolio

Some of the active/passive split can be seen in a given portfolio’s pieces, and how granular the investor gets.

• Do you want to start at the individual security level, picking single stocks and bonds yourself, or paying someone to do that for you?
• Or would you rather zoom out and start with funds that track a predetermined list or “index” of said securities? These can cover entire asset classes, like treasury bonds, or represent a “sub-asset” slice of a market, like short-term treasury bonds.

Stock indexes are weighted by the current value of the companies within them. These market "capitalizations" ebb and flow, of course, so the makeup of indexes and the funds that track them naturally evolve over time. They're "self-cleansing" in that sense. Lower performers make up less and less of the index over time, just as higher performers become bigger slices. It's why the bulk of the S&P 500 today looks very different than it did 20 years ago.

Source: FactSet

There's also the hybrid “smart beta” approach to index fund investing. Here, a fund manager starts with a preset index before actively tailoring it based on a set of quantitative investment factors. We offer one such option in the form of the Goldman Sachs Smart Beta portfolio, which invests more heavily in companies with at least one of the following factors:

1. They’re cheap relative to their accounting value.
2. They tend to be sustainably profitable over time.
3. Their returns are relatively low in volatility.
4. They’ve been trending strongly upward in price.

Use the right tool for the job

All of this may be a lot to take in. But we can simplify things by bringing it all back to the big picture.

• Active investing seeks to beat the market. It’s typically higher-cost, and comes with relatively higher risk. In specific use cases, however, an experienced team can outperform related indexes.
• Passive investing aims to replicate market returns at a lower cost, often over the long-term. It starts with the building block of funds instead of individual securities.

As is so often the case with investing, this isn’t an either/or proposition. We use both strategies—and sometimes a blend—at Betterment, because each has a role to play in building wealth. Regardless of whose hands are guiding your investing, we give you the tools to grow your money with confidence.