Let’s review what’s at stake here. Passive investing is based on the idea that the stock market is efficient, that all available information is priced into the market at any given time, so no other “smaller” set of information can consistently beat the market. It’s as if the market were one giant brain made up of the millions of brains that invest in stocks and bonds and thus determine the prices of those investments. How can one active brain consistently beat that?

Advocates of pure-passive investing yield points here: They admit that, from time to time, some investors and active fund managers will indeed be able to outperform the market, and they might attribute this performance to luck or excellent investment timing. However, because only a relative few can sustain such performance, the passive proponent offers the formula of indexing your investments.

When one “indexes,” one buys and holds a good representation of the market; one purchases the big market brain, or a facsimile of it, such as an index fund that mirrors the performance of actual stock or bond indexes. In this way, investors gain access to the true performance of the market. And because markets have proven they will climb upward over the long haul, this is smart, safe, market-average investing.

Active investing, on the other hand, is founded on the belief that there are opportunities to perform better than the stock and bond markets. Stock pickers, who base their actions on seemingly uncountable methods, from charting stocks to evaluating company fundamentals to seeking undervalued, as-yet undiscovered opportunities, are the most active investors. But mutual funds can be considered active vehicles, and this is exactly where active investing thrives. When you own shares of a mutual fund, as more than 54 million U.S. households and 91 million investors do, you own part of a managed vehicle, with the managers regularly adjusting fund allocations in an attempt to bolster fund performance.^[2] It stands to reason that the better your manager is, the better your performance will be.

Any investor wants to “beat” the market. The only question is, is it possible to do so with regularity? Of course. The probability of doing so, however, changes from market cycle to market cycle. And this, from my perspective, is where the active versus passive debate ceases to be a debate at all.

When I speak of the “long haul,” I mean the total length of time you will be invested in the stock and bond markets. For latecomers, this can be 10 or 20 years; for those who start out young, 30 or 40 years. Over such periods, passive investing indeed appears to beat out active investing.

John Bogle, founder and former chairman of the Vanguard Group and a passionate advocate of passive investing, reports that the average S&P 500 index fund returned 12.8 percent annually in the 20-year period between 1983 and 2003, while the S&P 500 index, the benchmark for the fund, returned a nearly equivalent 13 percent.^[3] This is a clear indication of passive investing doing exactly what it should: delivering market-average results.

But Bogle also reports that the average stock mutual fund (or active fund) returned only 10 percent in this period, a full 2.8 percentage points below the average index fund. Many similar studies show that stock indexes and the passive funds that mirror them beat active funds, on average, over long periods of time. Add in the fees attached to owning these funds—transaction costs and tax penalties that do not apply to passive investments (at least, not to the level of active funds)—and the pure-passive case strengthens that much more.

Active managers, however, defend their fees. If you expect an active fund to outperform the market, why shouldn’t it cost you more than an index fund that only mirrors the market? Indeed, the knowledge of the active manager and the caretaking he or she provides must come with a price. Active managers point to periods of excellent performance, times when their funds ran circles around slow-footed passive investments. They do so because 1) they have indeed at times generated market-beating performance, and 2) they very much want your business.

Over the long haul, some fund managers will be more deserving of your business than others; they will beat the market more often than not. However, because it might be difficult to select such managers (never is there a year when all active funds “beat the market”), the passive argument gels into a homogenous whole: Stay safe, stay steady, believe in the efficiency of markets and that you are not smarter than the markets, invest in index funds, avoid transaction costs that don’t always justify themselves, realize sound gains, and enter retirement with average results.

Average, in the passive lexicon, is not a dirty word. It’s the law. Says Bogle,

Must we?

The investment community is pretty much divided into the active and passive camps. Though few in either camp will tell you this, you are free to roam between the two. Costs are involved in this practice. For one, there are the added taxes and fees that are a part of active investing. The fee, again, is the price of accessing the knowledge of the fund manager, while the added taxes come about when fund managers switch between investments, with each switch becoming a moment when capital gains taxes are realized.

Fund to fund, the added cost of taxes and fees varies. Taxes are attributable to the turnover rate of the funds, with low turnover (say, around 25 percent) representing a much more tax-advantaged situation than high turnover (say, 80 percent or more). Fees, including management and administrative costs, can run anywhere from 0.5 percent to 2 percent (or more) annually. Taking taxes and fees together, this is a hurdle. But it can be worth it.

True enough, even switching from an active to passive mode, or vice versa, has its costs: Often taxes are due when one leaves one investment for another. But because we have seen not only the existence of cycles, but the persistence of cycles over many years, I firmly believe that switching between the active and passive investment modes at the appropriate times will deliver gains that can easily hurdle these transaction costs.

This is really the crux of the active versus passive problem, as I see it. In terms of the debate, both parties are too absolute in their beliefs for any one investor’s good. Simply, I don’t think it is in the nature or best interest of any investor to be so rigid as to go all-passive or all-active all the time.

When you think about it, an investor is little more than a shopper, someone who compares and contrasts the range of investment products and purchases the ones that fit. As a consumer, do you shop in just one type of store? Or does it take of range of stores, from the lower to higher end, to meet all your shopping needs?

I would wager that you, like most readers, fall in with the latter group.

Let’s think of two diametrically opposed stores: Costco and Nordstrom. Costco, among the largest of the nationwide warehouse clubs, sells low-priced (and often quality) goods in bulk. You can buy name-brand clothes here, which you can select from giant bins. You also can purchase a whole rib-eye section of a cow, which, priced for bulk, is a lot cheaper per pound than beef at the supermarket. This shopping is very do-it-yourself: You grab a cart, cruise the wide and towering aisles, and select from an array of reasonably priced products that, though plentiful to the eye, are strictly limited to what Costco management could stock that day or week.

You compromise when you shop at Costco. If the bins fill with fleece jackets and you want one in blue, you might have to settle for one in black. If you need a box of Cheerios, you might have to buy three (or a king-size box because Costco sells in bulk). If you want to barbecue ribs tonight, you might have to switch to pork chops if that’s all the pig Costco has in stock. (It’s hard to tell Costco what you’re having for dinner; Costco usually tells you.)

Now let’s drive over to Nordstrom, where the scene changes dramatically. Instead of bins, industrial pallets, and 40-foot-high metal storage shelves, there are trendy departments, creative merchandising displays, name brands galore, and a good many service personnel at your disposal. Here you are not necessarily a shopper, but a client. If you buy a pair of pants in Costco that need alternations, you’re on your own. At Nordstrom, they adjust them on the premises. Need a personal shopping assistant? Nordstrom will oblige. And if Nordstrom doesn’t have an item you’re looking for, the notoriously uber-accommodating clerks will go out of their way to order it for you or find an alternative. Yes, this is a high-priced store, but in terms of selection, quality, and service, one can argue that you get what you pay for.

Even if you never have shopped at Costco or Nordstrom, my message here should be evident: No one store can provide all consumers with all the products they need to meet the requirements of their diverse and modern lives at the appropriate levels of price and value. Higher price, higher value? This is often not the case. But often it is. Sometimes you need a tailored suit, not a Costco specialty. Sometimes you need a few pairs of generic white socks, items that do not require a trip to Nordstrom.

Likewise, when you purchase active or passive investment products, you receive different things. Passive products are not necessarily “Costco-grade,” nor are all active products Nordstrom’s-equivalent. But as you slide from passive to active, you move from bulk items to more customized fare:

In the passive, lower-cost, standardized aisle, you have index funds that mirror the stocks or bonds in specific indexes, with some of the big brand-name providers including Vanguard and Fidelity. Then there are exchange-traded funds (ETFs), funds that mirror individual indexes (or asset classes, as they are reflected in indexes) and can be traded like individual stocks. Some of the more prominent ETF brand names are PowerShares, iShares, SPDRs (or “Spiders”), and ProShares. Over in the active, higher-cost, and customized aisle, the selection shifts to mutual funds (and on the higher shelves, hedge funds, which we investigate in greater depth in Chapter 17. Mutual funds are managed portfolios of stocks and bonds that are offered by a broad range of companies—JP Morgan, American Express, Goldman Sachs, Vanguard, Fidelity, Scudder, T. Rowe Price, and Dreyfus, to name a few. Mutual funds can be very thematic in how they are composed, falling into categories such as large-cap, small-cap, growth, value, international, and fixed income—and the full range of combinations of each. There are also sector funds that track various industries (health care, retail, technology, utilities, etc.), global funds that invest both domestically and abroad, and lifecycled funds that will rebalance the equity/fixed-income split as you age.

Transaction costs, again, also increase as we move from passive to active, as does risk, in many cases. Yet so does the possibility (and, at times, the probability) of increased return, even after transaction costs are counted.

In 1970, Eugene Fama, working off his dissertation from the University of Chicago, constructed the ammunition store from which scores of passive advocates flocked to load their guns.^[5] Fama is the father of the efficient market theory, which boils down to the postulate that markets are smarter than you and that all relative market information is reflected in the current price of stocks. Thus, according to the theory, the future path of stocks cannot be predicted because no one person can possess such information (at least, not legally). The resulting prudent investment action must, then, be to index.

Without proof, such conclusions are rhetorical, but the passive crowd comes well armed with data. I already have reported John Bogle’s numbers, which show that the average active stock fund underperformed the average S&P 500 index fund by 2.8 percent between 1983 and 2003. Does this say that all active funds underperformed across the period or that all will underperform across any period deemed statistically long enough? Not at all, and here we can begin to discover a chink in the passive-only armor.

Rex Sinquefield, a co-founder of Dimensional Fund Advisors, a firm that helped pioneer index-fund investing, is a well-versed passive-investing advocate. In various speeches and articles, he has pointed to a range of studies that show how passive investing has a strong edge over active investing. In a speech in 1995, Sinquefield reported, “In the most recent and comprehensive study done to date, a dissertation at the University of Chicago, Mark Carhart studies a total of 1,892 funds that existed any time between 1961 and 1993. After adjusting for the common factors in returns, an equal-weighted portfolio of the funds underperformed by 1.8 percent per year.”^[6]

The Carhart study remains important; to this day, it is frequently referenced in the passive literature. But for our purposes, it is somewhat suspect. The sample size of 1,892 funds is statistically sound, as is the sample period, which covers a total of 16,109 fund years.^[7] In arranging his data, Carhart formed “ten equal-weighted portfolios of mutual funds” and tracked performance using a range of involved technical measures. Results aside for the moment, I’m very interested in one variable that both Carhart and Sinquefield mention: that of an equal-weighted portfolio. Bogle also uses an equal-weighted measure in ranking certain aspects of mutual-fund performance, leading us to wonder, what is an equal weight and why do proponents of passive-only investing regularly use it?^[8]

In the simplest terms, an equal-weighted index puts an equal value on each of the stocks it tracks. A capitalization-weighted index, on the other hand, gives a greater value to some stocks over others (see the sidebar “How Benchmark Indexes Are Constructed”). Because each stock in an equal-weighted index has an equal impact on the direction of that index, up or down, this same rule must apply to any equal-weighted ranking of mutual fund performance.

Indeed, if we apply an equal weight to the performance of a set of active mutual funds over a period of time, we will see an averaged performance of all these funds, where both the smallest and largest funds will have had an equal influence on the result. This gives us the Carhart/Sinquefield 1.8 percent underperformance of active funds over 32 years. Is this a fair result?

Well, if we apply a cap weight to the performance of these funds, we will identify a 50/50 weighted split of over- and underperformance. Sometimes one or a few funds will generate this outperformance (our cap-weighted stock index equivalent would be Wal-Mart on a good day), and at other times multiple funds will drive outperformance (say, a surf apparel chain, plus quite a few other small-caps, on a good day).

Critically, in this scheme, there always will be losers and winners, a division that, on average, will run 50/50 on a weighted basis, even though the number of fund names providing that performance can and will differ greatly.

And if there always will be winners, it is my belief that an opportunity exists to locate them.

We’ve come full circle to the idea that at any time in your investing life, you will want to have your portfolio correctly allocated to capture the overperformance of the economic times and avoid the underperformance. Because we now know that 50 percent of active funds must outperform at any time on a cap-weighted basis, we also know that the opportunity to capture these results at least perpetually exists. Undoubtedly, the passive-only recommendation that the only prudent way to invest must be to index must be wrong.

Importantly, however, and on a cap-weighted basis, the window of opportunity for active investing shifts from wide open to barely open and back again across your investing life. But of equal importance is the existence of a foolproof indicator of this shift: the size cycle.

In the following chapter, a rational walk down Wall Street and a few games of darts help bear out the fact that size cycles and the active versus passive choice are inextricably linked. Know your size cycles, and the active/passive decision becomes a process of turning a switch rather than making a one-time investment-life decision.