Passive and Active Investing Strategies
By Casper Shoghi
English 3003
Jami Barnett
TABLE OF CONTENTS
Abstract…………………………………………………………………………………………1
Executive Summary……………………………………………………………………………1
Introduction…………………………………………………………………………………….2
Methods…………………………………………………………………………………………3
Results…………………………………………………………………………………………..3
The Passive Argument…………………………………………………………………3
The Active Argument…………………………………………………………………..4
Conclusion………………………………………………………………………………………5
Glossary…………………………………………………………………………………………8
Works Cited…………………………………………………………………………………….9
LIST OF ILLUSTRATIONS
Portfolio Returns vs. Index Returns………………………………………………………….4
Rolling 12-Month Returns for S&P 500 ……………………………………………………..5
MEMO
TO: Readers in Finance field and finance majors
FROM: Casper Shoghi
SUBJECT: Research Report
DATE: March 26, 2013
ABSTRACT
In the world of portfolio* management, the debate between active and passive investing
strategies is ongoing between investors and portfolio managers. Passive investing is a long-term
strategy in which investors typically purchase securities without the expectation of immediate
returns. Rather, passive investors hold the belief that in the long-run, their investments will be
more profitable. This strategy is typically achieved by investing in index funds. An index fund is
a fund that very closely mirrors the returns on a stock index such as the S&P 500. Active
investors look more for short-term profits and monitor investments much more closely. Active
investors often seek to exploit inefficiencies in the market such as improperly priced securities
and profit from these errors. The argument in favor of active investing typically states that the
index returns can be beat, whereas passive investors are of the belief that the index cannot be
beat consistently and will not be beat by enough to justify the cost of active investing. Using the
online database EBSCOhost, research was conducted and scholarly articles were pulled from the
database to examine the arguments in favor of both strategies. This report will further explore
and compare the arguments in favor of active and passive investing strategies.
EXECUTIVE SUMMARY
In the world of portfolio management, the debate between active and passive investing strategies
is ongoing between investors and portfolio managers. The argument in favor of active investing
typically states that the index returns can be beat, whereas passive investors are of the belief that
the index cannot be beat consistently and will not be beat by enough to justify the extra costs of
active investing. These additional costs come from more research, advertisement, and trading.
Passive managers argue that active managers that do beat the index consistently are nearly
impossible to find, and yet, active managers point out investors’ knack for finding them. Active
managers also accuse passive managers of being victims of time-bias in their studies. It appears
that active and passive investing strategies both provide valid arguments for why to invest in
their chosen strategies. Using the online database EBSCOhost, research was conducted and
scholarly articles were pulled from the database to examine the arguments in favor of both
strategies. This report will further explore and compare the arguments in favor of active and
passive investing strategies.
INTRODUCTION
In the world of investing, two broad investment strategies exist. These strategies are passive and
active investing. Passive investing is a long-term strategy in which a stock or portfolio of stocks
will be held for the long-term. A passive investor does not seek to profit from the daily changes
in price and believes that the “sit-and-wait” strategy will be more profitable in the end. On the
other hand, active investing is a short-term strategy. Instead of purchasing a stock and waiting
for it to increase in value over a long period of time, active investors are closely monitoring their
investments to exploit smaller changes in price.
Passive investing strategies are relatively new to the world of portfolio management while active
investing has been around since investing began. Passive investing strategies originated “in the
1950s and ‘60s, culminating in the launch of the first stock-index fund in 1973” (Gardner 22).
Since the inception of passive strategies, investment strategies have since begun to shift from
active strategies to passive strategies. This shift is partly because of the benchmarks being used
to evaluate portfolio managers and make them more accountable for their performance. Relative
to benchmarks, passive strategies lead to a decrease in uncertainty in a portfolio’s returns (Bird
and Woolley 303). These reasons are why this argument has come into the investment field.
The purpose of this report is to investigate the pros and cons of each strategy and compare the
two different views of whether an active or passive strategy will lead to more investment
success. Making a recommendation as to which strategy to use is beyond the scope of this report.
Instead, the report demonstrates how many of the points of argument between passive and active
investors are countered by the other. Both sides present highly sensible and viable arguments and
so a conclusion favoring one is not possible within the scope of this research.
Three sources were found and used that argue in favor of passive investing strategies compared
to active strategies. In the article “Passive Investing: A Second Look,” Chris Gardner defends
passive investing by attempting to counter some of the arguments active investors make against
passive investing. After providing this information, he then provides some broader, bulleted
points to end the argument in favor of passive. Next, Lee Hull also favors passive investing in his
article “Is Active Investing Better Than Passive Investing?”, but not before providing reasons as
to why people incorrectly compare active and passive investing strategies. Finally, Conrad De
Aenlle more concisely illustrates why passive investing wins in his article “In Investing, Passive
Beats Active.” Much of the information gathered by De Aenlle comes from interviews from an
analyst at Morningstar and financial planners.
Two articles were primarily used to argue for active investing strategies. In his article, “Passive
Investing: The Emperor Exposed?” Christopher Carosa aims to disprove many of the reasons
many investors swear by passive strategies. He believes that the passive versus active
management debate is victim to two crucial flaws that provide a strong case in favor of active
investing. These flaws will be discussed later in the report. Ron Bird and Paul Woolley provide a
case for active investing that focuses more on the economic effects of passive investing in their
article “Economic Implications of Passive Investing.” Though Bird and Woolley do not tend to
recommend active investing as much, they provide reasons as to how the trend of moving from
active to passive strategies could hurt the economy as well as investors.
The findings of this research do not allow for a recommendation to be made in favor of active or
passive investing, but important factors were found for both sides. In favor of passive investing,
managers argue that active investing is just too expensive for the amount of returns one receives.
Passive managers believe that active managers will not consistently beat the market to justify
those fees and that even if some did, they would be very difficult to find. Active managers argue
that historically, many do, in fact, find these active managers beating the market. They also argue
that passive investing may have negative effects on the economy as a whole.
The results of this research will be organized in two sections. The first section will provide the
argument in favor of passive investing. The second section will do the same in favor of active
investing. Throughout the research, it became evident that the comparison of the two is not
without its flaws and that the better strategy may vary from investor to investor. This will be
explored in the conclusion which will also provide more comparison of the two strategies and
how the articles seek to discredit the points of the opposing views.
METHODS
In order to explore the topic of active and passive investing strategies and their differences,
research was conducted via the EBSCOhost database to find articles on these strategies. The
criteria for selecting articles are as follows. First, the articles had to be scholarly, written by those
with higher education or vast knowledge in the field, and from a reputable source. Second, the
articles had to take a side in the passive versus active debate. The articles had to choose a side
because the intent of this report is to examine the discussion between both sides and thus, any
article in the middle of the spectrum would not be conducive in exploring this disagreement and
the often antagonizing dissent.
Once the articles were found, they were examined primarily for the reasons in which the authors
believed their chosen strategy was better than the other. These reasons were pulled from the
articles to be used in the results section of this paper. The points were also compared for
agreements within passive and active investors, respectively, for the sake of consistency between
those who chose the same strategy in order to ensure one consistent argument from multiple
authors.
From here, the arguments were compared and contrasted to each other to clarify the argument
and to demonstrate how both sides relate to each other. This comparison was done with the idea
that the reader would be able to understand how the two sides compare and how they counter the
other’s argument. Then, the reader will be better equipped to formulate his or her own
recommendation as to whether to invest passively or actively.
RESULTS
THE PASSIVE ARGUMENT
As previously stated, passive investing strategies have increased in popularity amongst investors
due to reasons the investors find convincing. Passive index funds “are funds that are very low
cost and designed to track a certain market index” (Hull 67). The tracking of a market index
means that the returns of the fund closely mirror the returns of an index. The chart titled
“Portfolio Returns vs. Index Returns” shows the similar monthly returns on an index fund
portfolio and the S&P 500 index from the period of January 2010 – October 2012. As one can
see, the portfolio’s movements echo that of the index very closely and the percent per month
returns are nearly the same with the portfolio slightly beating the index.
15
Portfolio Returns vs. Index Returns
Returns (% per Month)
10
5
Portfolio
0
Index
-5
-10
Month (Jan 10 - Oct 12)
Shoghi, Casper E. "Portfolio Management: Project 4."
Compared to the low cost it takes to manage index funds, actively managed funds have higher
costs for three reasons. First, actively managed funds require more research and more intensive
research costing managers more because managers have to pay the analyzers for the extra work.
Secondly, these funds “tend to have higher trading costs* “because they buy and sell more
frequently” (De Aenlle 1). And lastly, it costs managers more “for marketing to tell the world
how wonderful their funds are” (De Aenlle 1).
Active managers experiencing underperformance of their funds have blamed it on passive
investing, and since the introduction of passive investing “active managers were consistently
underperforming their true benchmarks*” (Gardner 22). These managers are accusing “the
index-fund tail of wagging the stock-market dog” (Gardner 22). However, a study by Burton
Malkiel and Aleksander Radisich in 2001 found that “the flow of money into the index funds
was totally unrelated to relative performance” and that “the underperformance of active
managers is fully explained by the extra costs they incur in their efforts to beat the market”
(Gardner 22).
There are, however, active managers that do very well, and active managers have said that
passive investors ‘ignore the “exceptional” manager’ (Gardner 67). Despite this, selecting a
manager that could consistently beat the index is nearly an impossible feat, and the idea that one
investor could actually profit consistently from the errors of others is difficult to imagine
(Gardner 22).
THE ACTIVE ARGUMENT
Active investors provide many reasons for the continued use of active investing strategies. It is
completely possible to locate “talented managers in any corner of the market who are not
overburdened by high expense ratios and have a proven ability to beat benchmarks over time”
(De Aenlle 1). The additional costs of active investing incurred for one of these managers is
offset because investors “have exhibited a consistent track record of investing in U.S. equity
funds that are more likely to outperform the S&P 500” (Carosa 62).
Passive investors could also be examining a specific time period and thus, be falling victim to
period-dependent bias. By using rolling 12-month returns (thus, eliminating any time period
bias) and a period of time from January 1975 to June 2004, it was found that the active funds
defeated the S&P 500 index about two-thirds of the time (Carosa 58). The table titled “Rolling
12-Month Returns for S&P 500” provides visual representation of this study.
Carosa, Christopher. "Passive Investing: The Emperor Exposed?"
Returns just beating the index are not enough, however. A study by Christopher Carosa found
that not only did U.S. equity funds beat the index, but that the statistical “certainty level is large
enough to suggest the possibility of a statistically significant difference between the U.S. equity
mutual fund returns and the S&P 500 returns” (Carosa 60).
Since passive investors most frequently create index funds to follow the market, the stocks
chosen to invest are typically more varied in their performance since there is much less research
conducted. Unlike active investors who believe in inefficiency in the market and exploiting
arbitrage* opportunities, passive investors “accept without demur the prices and quantities of
stock supplied by issuers of stocks contained in the index” (Bird and Woolley 307). With greater
investment in less profitable stocks and the trust passive investors have with the market, passive
managers are misallocating resources “resulting in lower economic growth and market returns
along with greater volatility associated with market bubbles” (Bird and Woolley 310). For this
reason, many of the investments made by passive managers are thought to be economically
wasteful in that greater investment in poor stocks hurts the economy. Additionally, if the market
goes down drastically, index fund managers will see their funds mirror this downfall.
CONCLUSION
The arguments in favor of active and passive investing strategies are both very convincing. It
would appear that both strategies are not without their flaws. Passive investors insisting that most
active investors do not consistently beat the index leads one to believe that a passive strategy
may be more beneficial than an active strategy. However, active managers counter by saying that
some active managers do consistently beat the index and that investors have shown a strong
ability to find these managers’ funds. From there, passive strategists claim that the added costs of
active management such as advertising and more frequent trading costs lead to profits that can
similarly be achieved or defeated by passive strategies.
Passive managers also seem to unanimously agree that active managers underperform their
benchmarks, and dismiss the notion that it is the fault of their funds as many active managers
would claim. However, active managers counter by saying that actively managed funds beat the
index the majority of the time, and accuse passive managers of falling victim to drawing
conclusions from too small a span of time. Additionally, passive strategists do not believe the
active strategist that can beat the index can be easily found, but active strategists insist that
investors have historically done so.
As more investors shift to passive strategies, the argument between passive and active strategists
is sure to continue. With the research conducted in this report, a recommendation in favor of
either strategy cannot be made. Rather, the recommendation that either can be a successful
strategy and that it depends on the personal preferences of investors can be made.
Glossary (Defintions from Investopedia.com)

Arbitrage - The simultaneous purchase and sale of an asset in order to profit from a
difference in the price. It is a trade that profits by exploiting price differences of identical
or similar financial instruments, on different markets or in different forms. Arbitrage
exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not
deviate substantially from fair value for long periods of time.

Benchmarks - A standard against which the performance of a security, mutual fund or
investment manager can be measured. Generally, broad market and market-segment stock
and bond indexes are used for this purpose.

Portfolio - A grouping of financial assets such as stocks, bonds and cash equivalents, as
well as their mutual, exchange-traded and closed-fund counterparts. Portfolios are held
directly by investors and/or managed by financial professionals.

Trading Costs - Expenses incurred when buying or selling securities. Trading costs
include brokers' commissions and spreads (the difference between the price the dealer
paid for a security and the price the buyer pays).
Works Cited
Bird, Ron, and Paul Woolley. "Economic Implications of Passive Investing." EBSCOhost. N.p.,
30 Sept. 2002. Web. 26 Mar. 2013. <http://0web.ebscohost.com.library.utulsa.edu/ehost/pdfviewer/pdfviewer?sid=c6d62845-23724325-bef8-262e01619fda%40sessionmgr10&vid=11&hid=27>.
Carosa, Christopher. "Passive Investing: The Emperor Exposed?" EBSCOhost. N.p., Oct. 2005.
Web. 26 Mar. 2013. <http://0web.ebscohost.com.library.utulsa.edu/ehost/pdfviewer/pdfviewer?sid=c6d62845-23724325-bef8-262e01619fda%40sessionmgr10&vid=9&hid=27>.
De Aenlle, Conrad. "In Investing, Passive Beats Active." New York Times 12 May 2007: C6(L).
Business Insights: Essentials. Web. 25 Mar. 2013.
Gardner, Chris. "Passive Investing: A Second Look." EBSCOhost. N.p., 14 Feb. 2003. Web. 27
Mar. 2013. <http://0web.ebscohost.com.library.utulsa.edu/ehost/detail?vid=6&sid=c6d62845-2372-4325-bef8262e01619fda%40sessionmgr10&hid=27&bdata=JnNpdGU9ZWhvc3QtbGl2ZQ%3d%3d#d
b=bwh&AN=9136107>.
Hull, Lee. "Is Active Investing Better than Passive Investing?" EBSCOhost. N.p., Sept. 2011.
Web. <http://0web.ebscohost.com.library.utulsa.edu/ehost/pdfviewer/pdfviewer?sid=ff6d8c97-a442-4a8ca70d-a3c2a150f49a%40sessionmgr13&vid=11&hid=9>.
Investopedia. N.p., n.d. Web. 31 Mar. 2013. <http://www.investopedia.com/>.
Shoghi, Casper E. "Portfolio Management: Project 4." 4 Apr. 2013.