There are two fundamental approaches to investing in stocks and bonds. Active and passive investing. In this post, I will explain why I think that passive investing is the best solution for most people.
Difference between active and passive investing
Passive investing
Passive investors invest in funds that replicate market indexes. Indexes are a group of stocks and bonds to represent a market, for instance, the total stock market of a country. The criteria to select companies in an index are transparent and specified upfront.
One of the most famous indexes is the S&P500. It represents the 500 largest companies publicly listed in the United States. Companies are represented in the S&P500 index based on the size of their market capitalization (their value).
You can invest in an index by investing in a fund, either an ETF or mutual fund, that passively replicates the portfolio of the index. For this reason, they are called index funds. For instance, the most famous ETF in the United States that replicates the S&P500 index is SPY.
Active investing
Active investors, on the other hand, select individual stocks and bonds hoping to outperform one market index. As the name suggests, active investing requires time and effort to continuously evaluate stocks and bonds. It also requires extensive financial knowledge.
There are also many actively managed funds for investors who lack the time or financial skills to select investments. That means that investors will pay active fund managers a fee to select stocks and bonds on their behalf. Many mutual funds fall into the active managed funds category, but not all of them. The strategy of each fund is specified in their prospectus.
Financial performance of active and passive investing
Many studies have consistently shown that passively managed funds financially outperform active investment funds in the long term. There are many reasons why active managers tend to underperform the market. First of all, it is extremely difficult for active managers to put together portfolios that beat the market in the long run. Furthermore, actively managed funds charge higher fees than passive funds. When the fees are taken into account, active managers have a major disadvantage compared to passive funds.
One of the most comprehensive studies is the semiannual scorecards released by SPIVA (S&P Indices versus Active). The scorecards compare the performance of active equity and fixed-income funds against their benchmark. The benchmark is the market index that these funds are trying to beat.
In their 2021 Mid-Year Active vs. Passive Scorecard, they found that active fund managers recurringly failed to beat their S&P benchmarks across asset classes:
- 94% of US Equities fund managers failed to beat their benchmark
- 87% of Global Equities fund managers did not beat their benchmark
- 57% to 100% of Fixed Income fund managers underperformed their benchmark, depending on the fixed income investment style.
The underperformance of active managers is not news to investment professionals. If you look for studies online, you will find many that reach similar conclusions. Here is a recent 2022 article by Reuters, a 2021 article by the Financial Times, and a longer study on SSRN from David Nanigian at San Diego State University. Do I need to go on or did I convince you by now?
Passive performance is not indicative of future returns
The bottom line is that choosing active managers is difficult. You don’t know which are the very few active funds will outperform the market in advance. You cannot even rely on the past performance of actively managed funds. Past performance is unfortunately useless, or even counterproductive.
Jack Bogle, the founder of Vanguard and pioneer of passive investing, used to describe this phenomenon as “reversion to the mean”. Active funds that outperformed the market in one period, will have a tendency to align their performance to the mean market performance in the long run. So if you pick an active fund just because it outperformed in the last few years, you may end up investing in a fund that will underperform this year.
Beware of financial advisors who recommend active funds
Some financial advisors who recommend active funds will try to convince you that their active managers will beat the market. After all, they want to justify the fees they charge you by selecting managers and complex products. They will introduce concepts such as beta and alpha, and ask rhetorical questions such as “why would you ever buy the whole market instead of letting this super-skilled manager select the best companies for you?”. Obviously, this ignores the fees that you are paying these managers whether they outperform the market or not.
Verifying financial performance
If you talk to an advisor who tells you that you should invest in actively managed funds, before doing so compare the financial performance after fees of the funds that they recommend against the financial performance of index funds. You can do that on Morningstar. It is important that you compare them over a fairly long period, like 10-20 years.
Simply head to www.morningstar.com, then search for the fund(s) that they recommended, click on “performance”, then “show interactive chart”. Finally, enter as a benchmark major index funds. For the total USA stock market, you can select VTSAX. If you are looking at US large cap only, you can compare the performance to SPY for the S&P500. To compare the performance of funds that invest globally, you can also select index funds that track the MSCI World or FTSE Global All Cap Index. It is important that you pick a long time period, 10 years or more.
Running this 30 seconds check will give you the answer to your questions.
Of course, advisors may cherry-pick those funds that did well recently. The real challenge is to tell you which ones will outperform the market in the future. That is the real test because you are investing for the future, not for the past. So let them tell you which funds they would recommend for the future and compare their performance with the index after two or three years.
The compounding effect on high fees on your portfolio
By the way, I am not suggesting that all advisors are bad. Regulated advisors with fiduciary duties (unlike brokers) must act in your best interest. They are experts at suggesting a good asset allocation and keeping your emotions in check when the market takes a downturn and you are tempted to sell. So by all means work with an advisor if you don’t feel empowered or knowledgeable to invest on your own.
But if your advisor recommends active funds that charge 1.5-2% fees, be aware that it might make you lose even half of your wealth in the long run. To understand this concept I will need to refer to Jack Bogle once more in this post. He described the mathematical impact of fees over the long-term financial performance as the “tyranny of compounding cost”. Check out this short video because he explains better than I can. And there are many other videos where he explains how fees impact the financial performance of portfolios.
To the active stockpickers, Jack Bogle responded that instead of trying to find the needle in the haystack, with an index fund you can just buy the whole haystack!
Passive investing approach
Passive investing is a way simpler approach to building a portfolio than picking stocks yourself or hoping to find the very few active managers who can beat the market. You simply need to regularly invest in broadly diversified mutual funds or ETFs that replicate major market indexes.
Once you have invested, you need to take a buy-and-hold approach and maintain your investments in the long term. If your asset allocation is right for you, you can simply ignore what the market is doing in the short term. Just sit back and let your portfolio grow for as many years as possible, possibly 15-20 years or more. The compounding returns of the stock markets will do the job for you.
Benefits of market indexes diversification
Warren Buffett, widely considered to be one of the most successful investors in history, once said that “diversification is protection against ignorance. It makes little sense if you know what you are doing.” And that is exactly what we are striving for: blatant ignorance! In other words, we want to have a passive investment portfolio that allows us to blatantly ignore the market and let the money do the work for us, without putting any effort into it.
In 2013, in a letter to Berkshire Hathaway investors, Warren Buffett wrote that, upon his passing, the trustee of his wife’s inheritance was instructed to invest 90% of their wealth into a low fee index fund replicating the S&P500. So even one of the most legendary active investors recommends index investing to his wife because he knows too well that it is extremely difficult to beat the market.
The reason why Warren Buffett is so legendary is that he is one of the few who could beat the market for so many years. Furthermore, he did not beat the market with a mutual fund structure. He uses a holding company with meaningful or controlling ownership stakes in the portfolio businesses.
Self cleansing power of market indexes
If you are worried that by buying into the index you are also buying companies that are not doing well, just keep in mind that most indexes weigh their portfolio based on each company’s market capitalization. In other words, your exposure to companies that are doing well will increase over time as their weight in the index increases. The companies that do poorly will eventually fall out of the index. JL Collins, one of the FIRE titans out there, calls this dynamic “self-cleansing”.
Since you don’t know which companies will do well in advance, with an index fund you are open to all the opportunities in that market. Don’t estimate the power of the underdogs!