Yahoo U: Active vs. passive investing

Yahoo Finance's Brian Cheung breaks down active versus passive investing in this week's Yahoo U.

Video Transcript

ZACK GUZMAN: Welcome back to Yahoo Finance Live. In this week's Yahoo U, we're digging into a controversial issue. As a show that hosts a lot of stock pickers, maybe why stock picking might not be the best strategy and a debate among active and passive investors. And here to break that down in Yahoo U is Brian Cheung. Brian.

BRIAN CHEUNG: Well, hey, Zack. I'm kind of blindsided by what Jared had to say about that Bill Smead comment on active versus passive. But let me walk you through all of this because, of course, school never stops, so class is in session. And the biggest question in playing the stock market is often, is this play worth the investment? But in the great debate of active versus passive investing, the question is, really, is it worth the effort?

Now let me explain. So first off, the obvious, right? Active investing is a strategy where you're actively or cherry picking the stocks in your portfolio. So, by the way, this also means more than just having a Robinhood account. This would account for wealth managers or investment managers, basically anyone that builds portfolios, whereas pass, that's just buying the whole prepacked basket at the farm, right? The whole market, the S&P 500, for example.

Now I want to remind everyone that it doesn't always have to be the whole market. So there are exchange traded funds that target sectors like, for example, US large cap stocks or corporate bonds. That would count as passive investing, too, so, important to keep in mind.

Now, in general, these are the pros and cons of each investing strategy. Now, if you're picking individual stocks, you'd have more flexibility than you do with buying the whole market. And the big draw and the upside of being able to beat the market is really the big pull for active funds, right? Obviously, if your strategy is just owning the whole S&P 500, you can never, by definition, beat the S&P 500.

Now, the upside of passive on the other side of things is that it's much cheaper. So it's not free. Buying an ETF does come with a management fee and expense ratio. But it's going to be a few basis points. In some cases, maybe just five basis points. But compare that to hiring an active manager. That could run you 200, 300 basis points a year. That's a pretty big difference.

And then there's also transparency, right? If someone is day trading for you, it's going to be pretty hard for you to keep track of what your exposure is at any given point in time. Whereas if you're passive, you buy the whole thing and you sit back and you relax. And you can see exactly what's in that ETF that you're holding.

So the question, of course, here is, which one is better, A or B? Well, a reminder that it's all relative. So this has been the S&P 500 over the last five years. And you can see the trend, right? Stocks go up. Now if you were cherry picking, the question is not if you made money because of that. The question is whether or not you beat the market or if you underperformed the market.

So the question is, let's look at the numbers. How many active funds beat the market? And this right here is the answer. Among active funds that were looked at by Morningstar, only 42% of all US stock funds were able to beat the market in 2020. That was the worst circle that I've ever driven, by the-- drawn, by the way. But it's the same story if you break down all US stocks by market cap. So less than half, 45% of funds that are targeting small stocks beat the market, only 46% for mid-cap stocks, and then only 38% in large cap stocks. And by the way, this is where the Tesla, Facebook, big name stock fund managers are.

And underperformance by active funds have been a trend over, well, the last 15 years. Data comes from Bank of America Global Research. And it shows that trillions have flown into passive strategies for investing-- that's the blue line-- whereas trillions have flown out of active funds, the purple line. And again, this is US equity specifically-- keep that in mind. And it's important to note that this dynamic hasn't always been the case, though. So active fund managers, which would have been the purple line, were all the rage in the '80s and the '90s.

But again, this is US equities, and I want to point out that there are places right now where active investing is successful. So check this out for Morningstar. Maybe this is what Bill Smead and Jared Blikre were talking about here. But active funds did much better in these categories, so more than half in each of these four that I'm showing you. About 70% of active funds in diversified emerging markets outperformed their passive competition. And take a look at this. Real estate-- 71% of active funds, 7 in 10, that were playing in that market ended up beating the passive competition.

So I want to point out that there is a place for active right now. It's just not in US stocks. And here's the bottom line that I want to point out. There are definitely clear trends in investing versus-- passive, rather, versus active investing. But all of this is to underscore how difficult it really is to beat the market. I mean, some of our viewers might be casual players in Robinhood. And my take is that even if you don't outperform the market, if you had fun while you were doing it, there's some value in that right there as well. And that wraps up this week's Yahoo U. Zack and Akiko.

AKIKO FUJITA: Fun while you're doing it-- try telling that to people who have lots of money in some of these funds. But Brian Cheung, great as always. Appreciated that lesson there.