×

Passive investing is profitable, but there's a time to get active

As index funds and exchange-traded funds continue to outpace their actively managed mutual fund peers, the church of passive investors has enjoyed an undeniable membership surge.

Why pay for professional management, the argument goes, if they can't deliver higher returns?

Man sleeping in office
Dimitri Otis | Getty Images

"There have been massive inflows into passive funds over the last few years," said Katie Nixon, chief investment officer of Northern Trust Wealth Management. "It's been so long since active funds have outperformed passive ones that people just got sick of it.

"They threw up their hands in 2014 after several years of pretty acute underperformance, found an index fund and called it a day."

It's easy to see why.

The S&P Indices Versus Active (SPIVA) scorecard, which measures the performance of actively managed funds against their respective benchmarks, found 87 percent of large capitalization fund managers underperformed the S&P 500 Index over the last five years, and 82 percent failed to deliver incremental returns over the last decade.

Read MoreMaking money, making a difference

Similarly, Northern Trust Wealth Management found that 84 percent of actively managed domestic mutual funds, regardless of market cap, underperformed their respective benchmarks between December 2004 and December 2014.

Proponents of passive investment strategy, a concept championed by Vanguard Group founder and former CEO Jack Bogle, maintain that low-cost index funds and exchange-traded funds, or ETFs, are the better bet for investors over the long haul, since higher fees and taxable distributions negate any real return that most active fund managers eke out.

Index funds seek to replicate a market index, such as the S&P 500 or Dow Jones Industrial Average, by owning all securities in that index. They do not pay fund managers to actively select the allocation of stocks or bonds within the fund, which translates into lower fees.

The average expense ratio for all passively managed funds—including domestic, international, sector, commodities, fixed income and alternatives—is 0.91 percent, compared with 1.23 percent for the average actively managed fund, according to Morningstar.

Sitting tight

Index equity funds are far less pricey still, averaging roughly 0.25 percent. For its part, the Vanguard 500 Index fund charges 0.17 percent.

Passive investors, also known as buy-and-hold, do not seek to profit from short-term price fluctuations or attempt to time the market. Instead, they assemble a broadly diversified portfolio of funds across and between market sectors. Then they sit tight.

"A person who has a longer investment horizon would likely benefit more by owning only index funds and making sure they keep emotions off the table," said Herb White, a certified financial planner with Life Certain Wealth Strategies.

"Indexes, like all investments, have good days and bad days, so the investor has to be disciplined enough to stay the course when things are down."

Passive investment funds, he said, are also ideal for those who favor a hands-off approach and have neither the expertise nor inclination to educate themselves on market nuance.

Chris Cook, president of Beacon Capital Management, agrees that a passive investment strategy is appropriate for most investors but said he also sees value in monitoring the market.

Most of Cook's clients are nearing retirement or already there and lack the time horizon to wait for a market recovery. Thus, if the stock market dips by 10 percent or more, he intervenes.

"When the market drops by that amount, there's a 50 percent chance it'll drop another 10 percent," Cook said. "Half the time it's just a correction, and half the time it's a bear market, but we err on the side of safety.

Read MoreKeep investments unemotional

"That's when we start looking really hard at fixed income," he added.

To ensure diversification for his passive portfolio, Cook relies heavily on Vanguard's collection of 11 U.S. industry sector ETFs and one international sector ETF. "We weight them equally so we don't have to worry about style drift, which keeps the portfolio pure," he said, noting the model is not designed to chase returns in a bull market; it's designed for stability.

Despite their dismal track record of late, mutual funds managed by a market professional may still have a place in the average investor's portfolio, said Nixon at Northern Trust Wealth Management.

Indeed, many investors have a bit of both.

Index or more active?

"We're not prescriptive in terms of mandating that clients embrace either strategy," she said. "We recognize the benefits and drawbacks of the different approaches and let our clients' needs determine which approach we use."

Clients whose financial goals are fully met by achieving the market return, less a minimal expense fee, are advised to stick with index funds, while those who need (or wish) to generate more might be advised to select more active funds, said Nixon.

"For many investors, risk is a requirement because they have a required return to meet their goals, which might be lifestyle post-retirement, their child's education or the desire to buy a second home in eight years," she said. "If your assets based on our conservative assumptions about what the markets are going to give you over the next five to 10 years aren't enough to allow you to meet those goals, you're going to need to take more risk."

But not just any actively managed fund will do.

Read MoreWhen to not act your age in investing

Because the vast majority of fund managers fail to beat their benchmark, Nixon said it's necessary to differentiate between those who generate true alpha (that portion of return above and beyond what the market delivers) and those who merely assume greater risk.

"If you're going to pursue active funds, you need a rigorous tool set to tease out true alpha," she said. "A lot of times what looks like alpha is really the manager taking more risk than their benchmark.

"I don't need to pay those expense ratios to get more risk into my portfolio."

In the active manager selection process, Nixon also screens for track record, noting past performance is no guarantee of future returns.

"A lot of active managers are closet benchmarkers. They hug their benchmark, and you really want to avoid them." -Katie Nixon, chief investment officer at Northern Trust Wealth Management

"Everyone has a hot hand now and then, so you need to determine whether it's random or persistent, and what we find in a very small subset of managers is that there can be true alpha that survives after fees," she said.

The new Morningstar Active/Passive Barometer, which measures the relative performance of active U.S. fund managers against passive U.S. funds within their respective Morningstar categories, can help.

According to Nixon, the managers who consistently beat the market tend to deviate from their benchmark, using data, expertise and bravado. "A lot of active managers are closet benchmarkers," she said. "They hug their benchmark, and you really want to avoid them."

She added, "We want managers who have unique investment processes, and they are very hard to find."

The third way

Somewhere between active and passive mutual funds, said Nixon, lies a third investment strategy that may appeal to investors who need more from the market than an index fund can generate but aren't willing to pay for traditional active management.

Engineered beta, or enhanced indexing, starts with an index fund but adds exposure to certain asset classes that tend to reward investors over the long run.

Historically, for example, small companies outperform large capitalization stocks, while value outperforms growth.

Thus, if you take a domestic large-cap index fund and tilt it toward smaller stocks and value, your expected rate of return will be slightly higher with similarly low fees—although not quite as low as a traditional index fund.

Read MoreAre target-date funds a good fit for you?

"That's not alpha," said Nixon. "It's enhanced indexing. Based on the history of the financial markets, that's a high confidence bet for investors who need more than just the index return."

Investors who pad their portfolios with a combination of active and passive funds can boost their return further by focusing on asset location and tax efficiency, said White at Life Certain Wealth Strategies.

Actively managed funds, for example, which distribute more short-term capital gains (a major drag on returns) should be held inside your individual retirement account, 401(k) plan or other tax-sheltered account, while passive funds are best parked in your non-retirement account.

Your Wealth: Weekly advice on managing your money

Sign up to get Your Wealth

Please enter a valid email address
Get this delivered to your inbox, and more info about about our products and service. Privacy Policy.

In the ongoing debate over active vs. passive strategy, one thing is clear: There's no one right answer for everyone.

Those willing to pay fund managers for their stock-picking expertise, however, should select their investments carefully, know the tax profile and be sure they're delivering true alpha.

"We are coming off a period of very robust five-year returns, but the next five years are not going to look like the last," said Nixon, adding, "When capital returns are lower, these decisions can have a meaningful impact on portfolios.

"We can't control inflation or market performance, but we can control taxes and fees."

—By Shelly Schwartz, special to CNBC.com