Active vs. Passive Investing: The Basics
There are basically two styles of investing: active and passive management. Active investors try to strategically beat the market average by analyzing market conditions and researching company financials to take advantage of opportunities. These investors tend to trade relatively frequent; hence, they are “active” investors. Passive investors are just the opposite. They seek to achieve exactly the market return. Because passive investors tend to hold all or nearly all stocks in the market, they tend to trade relatively infrequent.
You may be asking why anyone would want to achieve the market return (passive investing) when there are unquestionably money managers who achieve returns above the market average (active). William F. Sharpe, Stanford professor and Nobel Prize recipient, explains in his paper The Arithmetic of Active Management that the answer is “embarrassingly simple.” Because passive investors return precisely the market return before costs, average active investors must also equal the market return before costs. If the entire stock market is made up of active and passive investments and the returns of passive investments equal that of the market, then by the simple laws of mathematics, active investments must equal the market as well. Sharpe goes on to say that “because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive investment.” [5] This logic is simple mathematics and lays the foundation for why passive investments should be the sensible, long-term investment strategy for nearly all investors.
Active vs. Passive Investing: Performance
John Bogle created the Vanguard 500 Index Fund, the first index fund, for his newly formed company, The Vanguard Group, in 1976 and has been the face of passive investing ever since. Simply put, Bogle believes in passive investing. He believes that if investors hold low-cost index funds for the entire market, they will outperform the majority of investors long-term. Many studies back up this theory.
According to Lipper, a financial markets research and wholly owned subsidiary of Reuters Group, at the time the Vanguard 500 Index Fund was created in 1976, there were 260 actively managed domestic equity funds. As of December 2009, 124 have either merged or closed leaving 136 funds. If we examine the performance of those remaining funds and measure them against the performance of the Vanguard 500 Index Fund, the results are impressive. The Vanguard 500 Index beat 66% of surviving funds, but this is without taking into account survivorship bias, sales loads, and taxes. If we take out survivorship bias (count the number of funds that failed or closed during this 25-year stretch), the Vanguard 500 Index outperformed over 85% of actively managed funds. Using this data, Richard A. Ferri, founder of the investment firm Portfolio Solutions and Forbes columnist, believes that the Vanguard 500 Index Fund would have beat over 88% of active funds over the 25-year period if sales loads would have been factored in. While the Vanguard 500 did not have a sales load in 1985, many of the remaining 136 funds did. Ferri also examined the taxes factor with these funds. Index funds are inherently tax efficient because funds are not traded a lot throughout the year (less than 10% turnover). On the other hand, active funds average an annual turnover percentage of about 50% which generates more costs to the investor. Taking into account all the factors, Ferri predicts that over the 25-year period from 1985-2009, the Vanguard 500 Index Fund beat over 90% of the original 260 funds. [6]
John Bogle also performed a study (cited in Ferri 107) tracking actively managed mutual funds versus the Wilshire 5000, a total U.S. market benchmark. Bogle tracked a period from 1970-2009, and of the 355 general equity mutual funds that Bogle identified at the beginning of the period, 243 had closed or merged at the end of the 40-year period. That’s a failure rate of almost 70%! If we take a look at the remaining 112 funds, 71 failed to outperform the Wilshire 5000, which leaves 41 funds that outperformed the index. Of those 41 funds, 36 outperformed the index by less than 2%. If we took into account all costs of these actively managed funds, including sales loads and taxes, The Wilshire 5000 would have undoubtedly beat several more of these funds. Nonetheless, the Wilshire 5000 outperformed 63% of surviving funds and 88% of all funds. [7]
From these studies, you can obviously see that several funds do beat the market over a long period of time. However, the odds are not in your favor, and there is no way of knowing which funds will outperform the market in advance. If there was a way to predict superior performance, then this advantage would most certainly attract more money into the fund, hindering the fund manager’s ability to outperform the market. The simple fact is that the number of fund managers who can beat the index decade after decade can be counted on one hand. This claim can be backed up by John Bogle’s study in his book Bogle on Mutual Funds. In this study, Bogle ranked the top 20 equity mutual funds from 1972-1982 and then ranked how these exact funds finished the following decade from 1982-1992. The results are noteworthy:[8]
This kind of performance hardly supports the claim that top managers can repeat their performance over a long period of time. The average fund performed slightly above average for all funds, but the range in performance for the following decade ranked anywhere from 2 to 245 out of 309. This is not quite the long-term assurance a long-term investor should be looking for. Bogle tested the same period from 1982-2002 and saw a similar pattern:
As you can see and as you have always heard, excellent past performance does not guarantee future excellent returns. While the top 20 funds from 1982-1992 finished above the average fund, the range of rankings the following decade should make you think twice about trying to select a fund that consistently beats the market ( average fund ranked 350 out of 841 funds). In addition, just remember that the average fund here does not mean the market average (index fund). Bogle goes on to explain that the top 20 funds from 1972-1982 had a market return of 14.3% on average from 1982-1992, while the S&P 500 returns 16.1% during the same period. The top 20 funds from 1982-1992 had a return of 11.1% in the decade from 1992-2001, while the S&P 500 had a return of 12.6%.[9] The extremely tricky part of investing is picking one of those top 20 funds one decade and then hoping the following decade the fund does not collapse like so many funds have proven to do (See Top 5 funds of previous chart). An investor will most likely be investing over dozens of years, so trying to select a winning manager for multiple decades in a row does not make much sense. To put it simply, trying to select a winning fund over multiple decades is not the kind of chance you should be willing to take when an all-market index fund is more likely to give you above average returns (even more so after all costs) and is less risky.
As we discuss the likelihood that an actively managed fund can outperform a comparable index fund, it is easy to lose sight of the fact that nearly all individual portfolios have more than one fund. Allen S. Roth, founder of Wealth Logic, LLC and author of How a Second Grader Beats Wall Street, conducted a Monte Carlo simulation in which he tested the probability of one, five, and ten funds beating the index over stretches of one, five, ten and twenty-five years (assuming 2% expense fee for active funds and 0.23% expense fee for index funds). The results are eye-opening:[10]
You can see that Roth claims the chance of one fund outperforming the index over 25 years is only 12%, consistent with Ferri’s earlier claim that the Vanguard 500 Index Fund outperformed roughly 88% of all U.S. general equity funds over a 25-year period. These results alone will make you think twice about investing in actively managed funds, but Roth explains that this simulation did not take into account two key factors: taxes and emotions. As explained earlier, index funds are quite tax efficient because they have a very low turnover ratio which means less taxes to the IRS .On the other hand, actively managed have a much higher turnover ratio, so even if you don’t sell part any shares, you are still paying higher taxes because the fund manager is buying and selling the assets in the fund at a much higher rate. Roth estimates that using a buy-and-hold strategy by owning index funds can save an investor roughly one percent annually in lower taxes. The other factor is human emotions. It’s human nature to pour money into a fund when it is doing well, and often times investors pull money out of a fund when it struggles. Unfortunately for these investors, they often miss out on fund gains due to market timing. Roth estimates that market timing costs investors 1.5 percent per year. Roth next performed another Monte Carlo simulation taking into account this 1.5 percent penalty for adverse market timing (in addition to the difference in expense ratio). The one percent tax penalty is not included in the simulation because Roth explains that “we will give it the benefit of the doubt that no one would be silly enough to do active investing in a taxable account.” The result of the second simulation is even more stunning than the first:[11]
The results speak for themselves. If you are a long-term investor, which you should be, why would you risk your future by investing in actively managed funds? As a serious investor, it is important to know the odds or you are at risk of putting a major dent in your nest egg.
Just to strengthen the argument even further, Larry L. Martin conducted a similar study in the early 1990’s about return probabilities in his article “The Evolution of Passive versus Active Equity Management” in The Journal of Investing. His results seen below show a direr situation for the active investor:[12]
Rick Ferri also set out to find the truth about return probabilities. Using 100 randomly selected actively managed equity funds (100 of the 260 that existed since 1976 – see earlier study), Ferri generated 10,000 portfolios and compared the return to an all index portfolio. Ferri only studied the 5-year time frame, but only 5% of 5-fund portfolios outperformed the benchmark by more than 0.5%. A more detailed look at Ferri’s study is shown below: [13]
These results are comparable to Roth’s and Martin’s study. It is hard to imagine why anyone would take the risk of selecting multiple actively managed funds in his or her portfolio.
The Experts
At this point you may be thinking “sure indexing might work for someone who knows little about investing but if I pay an advisor or ‘expert’ on investing to manage my portfolio, shouldn't he or she be able to beat the market? After all, they are experts.” That is a great question. Let’s take a closer look.
Allan Roth raises a good point on fund managers in his book How a Second Grader Beats Wall Street:
"We adults seem to buy into the expectation that our active manager is really good, so we will be among the few who beat the market. Of course, if my manager is so good that he can beat all the other managers, then why isn't he working for the billion-dollar investors?” [14]
Roth’s words remind me of this New York investment firm that has called me multiple times to silicate their big investing ideas trying to gain a new client. If this firm’s performance was as good as it said it was, why would it be calling a guy who just graduated college and works in a small town in northern Illinois? It seems like there would be clients lining up at its door if their performance was as good as promoted.
In the October 2003 edition of Money magazine, the magazine created “the ultimate investment club” by asking 24 of the top money managers to choose their top stock to form a 34 stock portfolio. One would think that the brightest minds could put together a portfolio that not only beat the market but crushed it. So how did this portfolio perform over the next year? A portfolio constructed by some of the brightest investment minds returned -2.4% while the U.S. stock market returned 11.5%.[15] That’s nearly a 14% difference! I do not need to tell you the effect that has on your money growth.
The next example of star fund manager inferiority is exposed in The New York Times in a 1993 experiment. The newspaper challenged five top professional financial advisers to select and manage a $50,000 portfolio made up of mutual funds that could beat an index modeled after the S&P 500. By October 1999, nearly six years later, not one adviser had beaten the index. While the index had an annual return of 21%, the average of the fund managers was a measly 13.8%. In other words, the average advisers portfolio would have grown to $112,000 in six years while $50,000 invested in the index would have grown to $164,000.[16]
Rick Ferri may have explained it best in his March 2012 issue of Forbes magazine when he proclaimed “My advantage is that I know what I don’t know, and unlike most investment advisers, I don’t have to make believe I know more.”[17] The point is, it is extremely difficult to beat the market after costs and even harder to know which fund managers will do it before they actually beat the market, so it is best to stick with index funds.
Active vs. Passive Investing: Costs
One of the main reasons that passive investing is the best strategy for long-term investors is the cost aspect of investing. Total costs an investor pays for a fund is often hard to see because the costs are built into the return on the fund most of the time. It is not like you get a bill in the mail that you have to pay. There are many costs that go into an actively managed fund. First there is the operating cost, or the expense ratio, that is attached to every fund including index funds. Many funds also have front-end or back-end sales commissions, a charge an investor must pay either when the fund is purchased or sold. There is also fund opportunity cost. A mutual fund often has a small percentage of its funds in cash reserves which have a much lower return than it otherwise would in stocks. Next, there are the transaction costs, or the costs associated with buying and selling stocks in the fund. Possibly the most costly of extra expenses are taxes (if held in a taxable account). Active funds tend to have a much higher turnover ratio than index funds, so even if an investor is not selling the fund, the fund manager is buying and selling stocks out of the fund which leads to more taxes. All of these costs take a huge chunk out of the return of the investor. On November 23, 1999, John Bogle gave a speech entitled “Equity Fund Selection: The Needle or the Haystack?” to The American Association of Individual Investors in Philadelphia that outlined the dramatic effect that costs can have on portfolio returns. Bogle examined the returns and costs associated with the average all-market mutual fund and an all-market index fund over the 15-year period. The chart below summarizes his cost estimates between actively managed mutual funds and index funds: [18]
From the years 1984-1999, the market returned 16.9% according to Bogle. However, if you back out all of the costs listed above, the average actively managed fund earned only 11.2%, a 34% reduction! On the other hand, the no load, low-cost, low-turnover all-market index fund would have return 15.8%, or 41% more than the actively managed fund. Bogle further explains the staggering difference between the two percentages in dollar amounts. If an investor started with an initial investment of $10,000 in 1984, the investor who put all of his money in the average actively managed fund would have about $49,000 after costs and taxes. You may be thinking that gaining almost five times your money after 15 years is pretty good, which it is! However, the key here is relativity. If an investor grew his initial $10,000 investment in a low cost, all-market index fund, that money would have grown to $90,000 net of costs. Now let me ask you, would you rather have $90,000 or $49,000? Even if an investor eliminated the tax cost because the investment is in a tax-free account, the investment would only grow to $70,000, which is still $20,000 of the index fund return.[19] Costs make a huge difference.
Human Rational Against Indexing
It is easy to see why more people do not index. Everywhere you look there are advertisements for a fund that has outperformed the Lipper average or a fund manager raving about his/her superior performance last year. Wall Street does not want you to know the truth because it will cost those big banks and investment firms lots of money! Do you remember all those extra fees that active funds cost you? Well most of that money is going to these firms. Simply put, the more these fund managers trade in their active fund, the more money they get and the less money the investor has. If an investor only holds index funds, these active managers don’t have a chance to collect all these extra fees, and therefore, less money in their pocket and more money in the investor’s pocket.
Another reason why investors believe they can consistently beat the market is because of our education system. It’s amazing that students go through school learning all about science, math, language, and history but what is one thing that every student will eventually need to know? Money management. When everyone starts their career, saving for retirement becomes a must but most have no idea how to start because they never had a basic class on investing at any level of their education. This strategy is very simple to learn and understand, but instead, “investors” rely on popular news outlets to tell us where to invest, which often leads to a much less satisfying investment return in the end.
Let’s go back to Allan Roth’s quotation when he urges investors to ask themselves, “if my manager is so good that he can beat all the other managers, then why isn't he working for the billion-dollar investors?”[20] It is a valid question, but humans in general don’t want to believe they are average or below average. They believe they can choose a wining manager because they put in the time and studied the numbers. It is easy to choose a manager who has a good track record the last ten years. As we showed earlier, though, past success is not an indication of future success, and it is very hard to tell who these top managers will be in advance. There will always be a group of investors who beat the markets. Always. Whether they beat the market because of luck or skill is another discussion (most academic research points to luck over skill), but as Greek shipping tycoon Aristotle Onassis once observed, “The secret of success in business is knowing something no one else knows.”[21] The fact is that the very large majority of investors do not have superior information, nor do they have the time and resources to try and find it. They read the paper, watch the news, and maybe even read a blog or two, but this is not superior information. This information is available to everyone. Thus, the best strategy for most investors is holding the entire market through low-cost index fund, and when it is time to retire, I would bet you are satisfied with your investment returns.
[5]
Sharpe, William F. “The Arithmetic of Active Management.” The Financial Analysts’ Journal Vol. 47, No. 1, January/February
1991, p. 7-9.
[6]Ferri,
Richard A. The Power of Passive
Investing: More Wealth with Less Work (Hoboken, NJ: John Wiley & Sons, 2011) 37-39
[8]
Bogle, John C. “Three Challenges of Investing: Active Management, Market
Efficiency, and Selecting Managers.” Client Conference, Boston, MA. 21 Oct.
2001.
[9] Bogle,
John C. “Three Challenges of Investing: Active Management, Market Efficiency,
and Selecting Managers.” Client Conference, Boston, MA. 21 Oct. 2001.
[10]
Roth, Allan S. How a Second Grader Beats
Wall Street: Golden Rules Any Investor Can Learn (Hoboken, NJ: John Wiley
& Sons, 2009) 97-99.
[11] Roth,
Allan S. How a Second Grader Beats Wall
Street: Golden Rules Any Investor Can Learn (Hoboken, NJ: John Wiley &
Sons, 2009) 99-102.
[12] Larry Martin, “The
Evolution of Passive versus Active Equity Management,” The Journal of Investing (Spring 1993) : 17-20 via Power of Passive
Investing
[13] Ferri, Richard A. The Power of Passive Investing: More
Wealth with Less Work (Hoboken, NJ: John Wiley & Sons, 2011) 87.
[14]
Roth, Allan S. How a Second Grader Beats
Wall Street: Golden Rules Any Investor Can Learn (Hoboken, NJ: John Wiley
& Sons, 2009) 9.
[15]
Roth, Allan. “Beating the Market.” The
Colorado Springs on the Web. 19 Nov. 2004. 27 Oct. 2012. <http://www.daretobedull.com>.
[17]
Ferri, Richard. “Why Smart People Fail to Beat the Market.” Forbes March 2012. 27 Oct. 2012
<http://www.forbes.com>.
[20]
Roth, Allan S. How a Second Grader Beats
Wall Street: Golden Rules Any Investor Can Learn (Hoboken, NJ: John Wiley
& Sons, 2009) 9.
