The Case for Passive Investing over Active Management

Active managers try to sell investors on their superior knowledge, skill, and experience, but they often neglect to mention that over the long term, active management rarely outperforms a passive strategy.

If you recall from any Economics or Finance class, the market is efficient, with all information readily available to prospective investors. 

It seems that investors are catching on, as evidenced by Morningstar’s analysis of the recent history of fund inflows from 2014-2023. Morningstar reports that passively managed funds have attracted far more investors than actively managed, and it’s not hard to see why. 

In this article, we will present the keys to our case for a passive approach to investing.

Source: MorningStar

6 Keys to the Case for Passive Investing

We’ve identified six keys that make the case for a passive approach to investing as opposed to active management. 

  1. Lower costs
  2. Consistency in performance
  3. Simplicity (and transparency)
  4. Diversification
  5. Tax efficiency
  6. Less behavioral risk

Lower Costs

While many active managers promise big returns, they often fail to mention the added expenses and fees that come with their services. In comparison, passive funds (particularly those tracking broad market indices like the S&P 500) have significantly lowered expense ratios and fewer transaction fees due to the lack of active management.

While an active manager may earn his keep when the market is up, should the market dip, you’re paying a premium on top of a loss. Meanwhile, when you invest passively, these low fees and minimal transaction costs mean you get to keep more of your investment returns.

Performance Consistency

The data is clear. 

A Morningstar report of active versus passive fund performance shows that it is essentially a coin flip whether an active manager survived and beat the average passive fund. The reason for this is simple: the market is efficient, and there are very few arbitrage opportunities for active investors who wish to pick individual stocks.

While there are actively managed funds that have outperformed the market, this is more likely to be survivorship bias than anything else. The funds that underperformed are more likely to go out of business, removing them and their track records from view. Meanwhile, the S&P 500 has survived booms and busts for decades and so far has headed in one steady direction. 

Simplicity and Transparency

Active managers and market prognosticators will use special terminology to demonstrate superior expertise – in reality, setting your asset allocation and investing can and should be quite simple.

Rather than risk the high fees and transaction costs on a 50-50 chance that a complicated investing strategy could work, your time and energy are better spent investing in a straightforward index fund that replicates the performance of the entire market or a sector. Furthermore, unlike actively managed funds, passive investing means you know exactly what you’re getting and what it costs.

Diversification

The S&P 500 ended 2024 with a 23.3% gain, following a 24.2% gain in 2023. At the same time, shares of Nvidia rode the AI boom and increased by 170% in 2024. Would it have been better to go all in, riding the AI wave instead of the entire market?

While you might have been lucky to get on and off the AI train at the right time, it’s just that: luck. Active managers concentrate their portfolios on select stocks, which may work out if the stocks in question pay off but can have devastating consequences if they do not. 

Rather than search for the needle in the haystack, buy the entire haystack and ride the wave upwards. Index funds will provide immediate diversification and often include high-growth stocks like Nvidia, Tesla, and Apple. This gives you many of the same benefits of holding these stocks while reducing the risk associated with individual stock performance.

Tax Efficiency

Fewer transactions don’t just reduce your fees for a passive fund; they have key tax implications as well. Due to lower portfolio turnover, passive funds will have fewer capital gains distributions, leading to more tax-efficient investments. Compare that to active funds, where frequent trading can lead to higher tax liabilities on shorter-term gains.

Less Behavioral Risk

Active management can sometimes lead to emotional decisions driven by chasing performance, market timing, or reacting to short-term market volatility, behaviors that often detract from long-term investment returns. Passive investing encourages a “set and forget” approach, which can support a long-term investment strategy.

While passive investing doesn’t aim to beat the market, it does aim to match it, providing a more predictable and stable return profile over time.

Your Next Step to Investing Passively

At M3 Family Office, we believe that your needs and financial plan should dictate your asset allocation and not the other way around. By betting on the long-term growth of the economy and seeking out key opportunities for tax advantages and rewards, we assist our clients in developing a financial operating system to grow their wealth and pass it on to the next generation. 

While active management can occasionally outperform in certain market conditions or through specific strategies, the overarching benefits of passive index investing often outweigh the potential risks. 

Passive funds free you up to focus on other things as you ride the wave of the market, cost less, offer greater diversification, and result in lower tax penalties than actively managed counterparts. These advantages often make passive investing more appealing for long-term wealth accumulation.

This information is general in nature and should not be considered tax advice. Investors should consult with a qualified tax consultant as to their particular situation.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

M3 Family Office LLC  (“M3 Family Office”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where M3 Family Office and its representatives are properly licensed or exempt from licensure.