The Wall Street Journal recently published a series of articles under the title “The Passivists.” Highlighting the merits of a passive investment approach, authors tackle topics such as the fruitless endeavor of trying to pick winning stocks to the “Do Nothing All Day” investment approach taken by Nevada’s $35 Billion pension fund. For each article we provide a synopsis as well as our own additional comments to build upon the great work highlighted in this series.
Passive investing has taken the world by storm. Why are investors so eager to join the indexing revolution? It really comes down to these 5 things:
1. Historical Performance of Active Management Has Been Disappointing
As the authors in the WSJ article1 point out, the track record of active US Large Company Funds versus the Vanguard 500 Index fund over multiple time periods has not been great. Over the 1, 3, 5, 10, 15, 20, and 25 year periods ending June 30, 2016, no more than 37% of active mangers outperformed the Vanguard 500 Index at any given time. Doesn’t sound too promising for investors.
2. Performance Among the Winners Is Not Persistent
While we do, in fact, see some active managers outperform their respective benchmarks, they often end up falling behind in subsequent years, which raises the question of whether or not their initial outperformance was a result of skill or just simple luck. According to the article, “of the 20 best-performing actively managed U.S. stock funds for 10-year returns as of the end of 2005, only seven were better than average over the next decade.” In more practical terms, you have less chance of picking a winner based on past performance than flipping a fair coin.
3. You Are Paying A Lot and Receiving Very Little in Return
Fees matter A LOT when it comes to investing. Most actively managed funds are often 7 to 8 times more expensive than a passive alternative. As the authors astutely point out, the average annual fee associated with U.S. stock mutual funds is 0.77% versus 0.10% for passively managed mutual funds. Coupled with the fact that the vast majority of actively managed fund have underperformed their benchmark, investors have been hit with a 1-2 combo of higher fees and lower returns.
4. Morningstar’s 5 Star Rating System Provides No Assistance
As the article stipulates, “managers named by Morningstar as top performers for a given year generally didn’t perform as well relative to the S&P 500 in subsequent years.” Again, this begs the question of whether or not managers are displaying actual skill versus just being lucky.
5. Simply Put, It’s The Popular Thing To Do Right Now
Since 2005, the move into passively managed mutual funds and ETFs has exploded, reversing a trend that saw just a decade prior. For the 3-year period ending August 30, 2016, $1.3 Trillion has flowed into passive strategies while active strategies have lost almost 25% of their total assets under management over the same time period.
You can find the original article with charts published in the Wall Street Journal here.
 Jakab, Spencer, Sarah Krouse, Hanna Sender, and Jason Zweig. “Why Passive Investing is Overrunning Active, in Five Charts.” The Wall Street Journal. October 17, 2016. http://www.wsj.com/graphics/passive-investing-five-charts/
About the Authors
Tom Allen is an Accredited Investment Fiduciary (AIF®), Certified Cash Balance Consultant (CBC) and a Chartered Financial Analyst (CFA®) Level III Candidate. Tom received his Bachelor of Science in Management Science as well as his Bachelor of Art in Philosophy from the University of California, San Diego.
Mark Hebner - Founder, Index Fund Advisors, Inc.
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.