Three common misconceptions about passive investing.

The opposite of active investing is passive investing. It is index investing. It is buy-and-hold investing.

While active investing is like the ant in the fable that works tirelessly to improve, passive investing is like the grasshopper that just enjoys what the world can provide him.

To my mind, passive investing is like being a passenger in a car and having no say in where you are going but still being exposed to the risk of an accident.

I’m not a fan.

So I was surprised when I ran across a November 2013 survey of investors in which they were asked what they thought of active and passive investing. The survey was conducted by independent research firm Research Collaborative and was sponsored by the mutual fund company MFS Investment Management. It surveyed about 1,000 investors, each with more than $100,000 in investable assets.

What the survey showed was that there is an appalling lack of knowledge about what passive investing is all about.

These investors were asked whether they agreed with three statements about passive investing. More than 60% of the investors agreed with all three statements.

Misconception #1: “Where risk is concerned, passive investments are a safe bet.” (64% agreed)

A passive investment simply tries to represent the returns of an index. It is unmanaged in any sort of active way. Its whole purpose is to achieve the same return (less the expense of running the fund) as the underlying index.

So if it were a passive investment in the NASDAQ 100 Index (NDX), like the QQQ ETF, it would hold the same stocks in the same percentage as the NASDAQ Index published in the daily paper. That means in 2000-2002 it would have declined about 82.9%, and in 2007-2008 it would have lost 53.4%.

Yes, it was a safe bet that an investor would lose those amounts, but not a safe bet if there were a concern about the exposure to risk.

Passive investing has nothing to do with risk, per se. A passive investment can be risky, or not so risky, based on the risk level of its underlying index or asset class.

In my view, all passive investments that have any volatility (variation) in their returns are, by design, riskier than actively managed investments. Bonds, stocks, commodities, and precious metals can all be owned passively. They also can be very volatile. Hence, they do not have minimal risk.

There are two reasons to be an active investor: (1) the investor is trying to achieve returns in excess of the passively held index, or (2) the investor is trying to reduce risk through active management. Rarely can investors achieve both in a single strategy in the short run. As strategies are combined, it is more achievable, but even then it is usually over the course of a full market cycle encompassing both a 20%-plus bull and bear market, which usually occurs over a period of three to seven years.

I like to think of active management principally as a defensive tool. It is not tied to subjective feelings. It follows disciplined, by-the-numbers rules, or criteria. It is responsive to changes in market conditions—versus grinning and bearing it as a passive investor must.

It can accept small losses and hold on to large gains. It is psychologically sustainable, in that it is not designed to hold on to investments that are taking big losses. Investors committed to passive investing must simply take the loss in value and hope for an eventual comeback.

Misconception #2: “Passive investments almost always provide greater diversification than active investments.” (62% agreed)

Wrong! Passive investments can have no diversification (a gold ETF, for example), or they can have a great deal of diversification (an all-weather fund, like the Permanent Portfolio (PRPFX)). But passive investments, by their nature, are not diversified. In fact, if “diversified” means that they contain a large number of asset classes that behave differently from each other, very few are diversified.

Similarly, actively managed investments can have little or a lot of diversification, depending on the strategy being employed. But actively managed investments are virtually assured of being more diversified than passive investments that remain in a single asset class because to be “active” they must move to other investments or asset classes to follow their active strategy. Even an S&P 500 market-timing strategy must move between the S&P and something else—like bonds or a money-market fund.

In addition, maximum diversification cannot be achieved with asset-class investing in a passive portfolio. Instead, one needs to use all of the tools available. Therefore, an actively managed portfolio of actively managed strategies with access to multiple asset classes works to achieve greater diversification on more levels than a simple passive investment or a passive portfolio allocated to these index funds.

“Passive investing is like being a passenger in a car and having no say in where you are going but still being exposed to the risk of an accident.”

Misconception #3: “A passive investment could significantly beat its benchmark.” (62% agreed)

This one is just plain silly. Most passive investments seek to replicate an index, so the benchmark for the passive investment is that same index. It’s pretty difficult for an index to significantly outperform itself, right?

Furthermore, it is an oft-repeated small-print warning about indexes that “indexes are not tradable,” meaning investors can’t just buy the index and replicate its performance. Every index fund has costs associated with putting it together, maintaining it, and distributing it. The trading costs alone can be a big factor and virtually assure that most passive investments will underachieve their benchmarks.

Active investments can, and do, outperform their benchmarks, but it is often on the basis of their risk-adjusted return. Why? Because most active management is focused, first, on risk management; any payoff in return is designed to occur not in the short term but instead over a full market cycle. Since most indexes don’t do this, it is difficult to even find an appropriate benchmark for active investments.

There is an advantage to passive investments, and the media and indexing adherents never tire of reminding us of it: low cost. More than half of the survey respondents (52%) identified this as a selection criterion.

Of course, the lower cost is understandable. If there is very little involved in the management of the investment, the payoff to the manager should be lower. But investors have to ask themselves if they are being penny-wise and pound-foolish. Is the lower cost enough of an advantage to offset the designed benefits of active management—responsiveness to market environments, risk aversion, more complete diversification, and the opportunity to outperform the benchmark?

As Hall-of-Fame-broadcaster Ernie Harwell said, “He stood there like the house by the side of the road.”

That sums up my view of investors who follow a passive investing philosophy.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.