10 Reasons Investors Should Switch to Passive From Active

10 Reasons Investors Should Switch to Passive From Active

10 Reasons Investors Should Switch to Passive From Active

While we believe there are many reasons why investors should look into adopting a passive investment strategy that incorporates buying, holding, and rebalancing a globally diversified portfolio of index funds, here are ten.

 1. Markets Are Random: Markets are moved by news and news is unpredictable and random by definition. How quickly information is digested into the market as a whole is known as “market efficiency.” Since global markets are very efficient,  active management equates to attempting to predict the unpredictable. Market randomness makes stock picking, market timing, manager selection and style drifting a purely speculative activity, with negative expected returns relative to risk adjusted returns.

2. Markets Are Efficient: Piggybacking off of the previous point, markets have been shown to be highly efficient. Stock exchanges around the world simultaneously price the cost of capital and expected return of capitalism. Free markets perform this task most effectively since it brings together the collective knowledge of all investors into a single piece of information (i.e. the price). It is highly unlikely that a single investor knows more information about a particular security than the collective wisdom of the entire market.

3. Trying to Beat the Market is Difficult: For the 15-year period ending 12/31/2015, only 17% of active US equity mutual funds outperformed their respective benchmarks. Further, only 43% even survived the entire 15-year period.[1]  Of those that do win, persistence is very low. According to SPIVA, only 3.7% of large-cap funds, 5.79% of mid-cap funds, and 7.82% of small-cap funds maintained top-half performance over five consecutive 12-month periods. Random expectations would suggest a repeat rate of 6.25%. Thus, for those managers that do outperform their benchmark, it is hard to decipher whether it was due to luck or skill.

4. Fees Matter: On average, active US equity mutual funds are 7 to 8 times more expensive than passive funds of a similar asset class.[2] A 1% difference in overall cost over the course of 30 years equates to a 25% reduction in accumulated wealth if higher fees are not accompanied with higher returns. Morningstar has determined that fees are “one of the only reliable predictors of success.”[3]

5 Long Term Market Returns are Attractive to Begin With: From 1928-2015, the S&P 500 has delivered a 9.27% annualized return. This equates to an investor doubling their money every 8 years or about 5 times over their working life (40 years). From 1928-2015, a globally diversified portfolio with a tilt towards small cap and value stocks has delivered an 11.49% annualized return.[4][5] This would equate to an investor doubling their money every 6 years or about 7 times over their working life. For example, a $30 million pension would have grown to $264 million over a 20-year period with these type of market returns (assuming no additions or withdrawals).[6]

6. Better Diversification: Diversification reduces firm specific risks that do not compensate investors with additional return.[7] Most passive funds hold hundreds to thousands of individual securities at a relatively low cost.[8] Passive funds are available for most asset classes around the world, which allows investors to build a globally diversified portfolio.

7. Better Risk Management: Passive funds allow for better control over risk in a portfolio because we have a better expectation of future risk and return. Investors can structure their asset allocation in a way that maximizes their return for a given level of risk (i.e. Modern Portfolio Theory). Passive funds can also be utilized to target known risk premiums in the market that have been shown to compensate investors with additional return.[9]

8. Better Understanding of Risk: The expected return of any given company is tied to the risk associated with that company. The riskier the company, the higher the expected return for those who are willing to bear that risk. The “best” companies don’t necessarily make the best investments. A study conducted in 2010 confirmed that companies with the highest “Fortune” ratings (admired) underperformed those with the lowest “Fortune” ratings (spurned) by 2.31% per year over the 24 year, 9 month period ending 12/31/2007.[10]

9. Embrace the Right Types of Risk: Not all risks are created equal. There are 3 known risk premiums associated with higher expected returns:[11]

a.  Market – (inflation, recession, wars, etc.)

b.  Size – (small companies versus large companies)

c.  Relative Price – (value stocks versus growth stocks)

The Fama/French US Small Value Index has outperformed the Fama/French US Large Growth Index by 4.26% per year from July 1926 to September 2016.[12] Investors can structure passive portfolios that target these drivers of expected stock returns.

10. Peace of Mind:  Once you do adopt a passive investment strategy, you can finally invest and relax. Markets will act as an ally to constantly price risk based off of news to ensure that investors are expected to earn a fair return. Because short term market movements can be characterized as random, investors can tune out of the daily noise and focus on the long term expected returns.



[1] “Pursuing a Better Investment Experience.” Dimensional Fund Advisors, LP. April 2016

[2] Based on active US equity mutual funds. The average for active funds is 0.77% and 0.10% for passive funds (http://www.wsj.com/graphics/passive-investing-five-charts/)

[5] Known dimensions of expected return most thoroughly addressed in Fama/French’s 1992 paper “The Cross-Section of Expected Stock Returns”

[6] Very simplisitic analogy, but shows the attractiveness of just accepting market returns.

[7] Idiosyncratic (firm specific) risk is not expected to compensate investors because investors can remove that risk from their portfolio for free (without sacrificing return)

[8] For example, the Vanguard Total World Stock Index holds 7,627 individual companies around the world

[9] Market, size, and relative price (value). These factors were most adequately reviewed in Fama/French’s 1992 paper, “The Cross Section of Expected Stock Returns

[10] Meir Statman and Deniz Anginer, "Stocks of Admired Companies and Spurned Ones," Santa Clara University Leavey School of Business, Research Paper No. 10-02 (2010).

[11] Known dimensions of expected return most thoroughly addressed in Fama/French’s 1992 paper “The Cross-Section of Expected Stock Returns”

[12] Best estimate of the value of incorporating a small/value tilt in a portfolio

10 Reasons Investors Should Switch to Passive From Active

 

Tom Allen & Mark Hebner

 

While we believe there are many reasons why investors should look into adopting a passive investment strategy that incorporates buying, holding, and rebalancing a globally diversified portfolio of index funds, here are ten.

 

1.     Markets Are Random: Markets are moved by news and news is unpredictable and random by definition. How quickly information is digested into the market as a whole is known as “market efficiency.” If markets are efficient, then active management equates to attempting to predict the unpredictable and random, which we know is a futile endeavor. This includes stock picking, market timing, style drifting, or attempting to select the next “all-star” fund manager.

2.     Markets Are Efficient: Piggybacking off of the previous point, markets have been shown to be highly efficient. Stock exchanges around the world simultaneously price the cost of capital and expected return of capitalism. Free markets perform this task most effectively since it brings together the collective knowledge of all investors into a single piece of information (i.e. the price). It is highly unlikely that a single investor knows more information about a particular security than the collective wisdom of the entire market.

3.     Trying to Beat the Market is Difficult: For the 15-year period ending 12/31/2015, only 17% of active US equity mutual funds outperformed their respective benchmarks. Further, only 43% even survived the entire 15-year period.[1]  Of those that do win, persistence is very low. According to SPIVA, only 3.7% of large-cap funds, 5.79% of mid-cap funds, and 7.82% of small-cap funds maintained top-half performance over five consecutive 12-month periods. Random expectations would suggest a repeat rate of 6.25%. Thus, for those managers that do outperform their benchmark, it is hard to decipher whether it was due to luck or skill.

4.     Fees Matter: On average, active US equity mutual funds are 7 to 8 times more expensive than passive funds of a similar asset class.[2] A 1% difference in overall cost over the course of 30 years equates to a 25% reduction in accumulated wealth if higher fees are not accompanied with higher returns. Morningstar has determined that fees are “one of the only reliable predictors of success.”[3]

5.     Long Term Market Returns are Attractive to Begin With: From 1928-2015, the S&P 500 has delivered a 9.27% annualized return. This equates to an investor doubling their money every 8 years or about 5 times over their working life (40 years). From 1928-2015, a globally diversified portfolio with a tilt towards small cap and value stocks has delivered an 11.49% annualized return.[4][5] This would equate to an investor doubling their money every 6 years or about 7 times over their working life. For example, a $30 million pension would have grown to $264 million over a 20-year period with these type of market returns (assuming no additions or withdrawals).[6]

6.     Better Diversification: Diversification reduces firm specific risks that do not compensate investors with additional return.[7] Most passive funds hold hundreds to thousands of individual securities at a relatively low cost.[8] Passive funds are available for most asset classes around the world, which allows investors to build a globally diversified portfolio.

7.     Better Risk Management: Passive funds allow for better control over risk in a portfolio because we have a better expectation of future risk and return. Investors can structure their asset allocation in a way that maximizes their return for a given level of risk (i.e. Modern Portfolio Theory). Passive funds can also be utilized to target known risk premiums in the market that have been shown to compensate investors with additional return.[9]

8.     Better Understanding of Risk: The expected return of any given company is tied to the risk associated with that company. The riskier the company, the higher the expected return for those who are willing to bear that risk. The “best” companies don’t necessarily make the best investments. A study conducted in 2010 confirmed that companies with the highest “Fortune” ratings (admired) underperformed those with the lowest “Fortune” ratings (spurned) by 2.31% per year over the 24 year, 9 month period ending 12/31/2007.[10]

9.     Embrace the Right Types of Risk: Not all risks are created equal. There are 3 known risk premiums associated with higher expected returns:[11]

a.      Market – (inflation, recession, wars, etc.)

b.     Size – (small companies versus large companies)

c.      Relative Price – (value stocks versus growth stocks)

The Fama/French US Small Value Index has outperformed the Fama/French US Large Growth Index by 4.26% per year from July 1926 to September 2016.[12] Investors can structure passive portfolios that target these drivers of expected stock returns.

10. Peace of Mind:  Once you do adopt a passive investment strategy, you can finally invest and relax. Markets will act as an ally to constantly price risk based off of news to ensure that investors are expected to earn a fair return. Because short term market movements can be characterized as random at best, investors can tune out of the daily noise and focus on the long game.

 



[1] Data based on the Center for Research in Security Prices (CRSP) Survivorship Free US Mutual Fund Database

[2] Based on active US equity mutual funds. The average for active funds is 0.77% and 0.10% for passive funds (http://www.wsj.com/graphics/passive-investing-five-charts/)

[3] http://www.investmentnews.com/article/20160819/FREE/160819916/fees-matter-most-when-it-comes-to-active-management-performance

[4] Based on historical performance of IFA Index Portfolio 100

[5] Small cap and value stocks have been shown to be higher sources of expected return.

[6] Very simplisitic analogy, but shows the attractiveness of just accepting market returns.

[7] Idiosyncratic (firm specific) risk is not expected to compensate investors because investors can remove that risk from their portfolio for free (without sacrificing return)

[8] For example, the Vanguard Total World Stock Index holds 7,627 individual companies around the world

[9] Market, size, and relative price (value). These factors were most adequately reviewed in Fama/French’s 1992 paper, “The Cross Section of Expected Stock Returns

[10] Meir Statman and Deniz Anginer, "Stocks of Admired Companies and Spurned Ones," Santa Clara University Leavey School of Business, Research Paper No. 10-02 (2010).

[11] Known dimensions of expected return most thoroughly addressed in Fama/French’s 1992 paper “The Cross-Section of Expected Stock Returns”

[12] Best estimate of the value of incorporating a small/value tilt in a portfolio

 

10 Reasons Investors Should Switch to Passive From Active

 

Tom Allen & Mark Hebner

 

While we believe there are many reasons why investors should look into adopting a passive investment strategy that incorporates buying, holding, and rebalancing a globally diversified portfolio of index funds, here are ten.

 

  1. 1.     Markets Are Random: Markets are moved by news and news is unpredictable and random by definition. How quickly information is digested into the market as a whole is known as “market efficiency.” If markets are efficient, then active management equates to attempting to predict the unpredictable and random, which we know is a futile endeavor. This includes stock picking, market timing, style drifting, or attempting to select the next “all-star” fund manager.
  2. 2.     Markets Are Efficient: Piggybacking off of the previous point, markets have been shown to be highly efficient. Stock exchanges around the world simultaneously price the cost of capital and expected return of capitalism. Free markets perform this task most effectively since it brings together the collective knowledge of all investors into a single piece of information (i.e. the price). It is highly unlikely that a single investor knows more information about a particular security than the collective wisdom of the entire market.
  3. 3.     Trying to Beat the Market is Difficult: For the 15-year period ending 12/31/2015, only 17% of active US equity mutual funds outperformed their respective benchmarks. Further, only 43% even survived the entire 15-year period.[1]  Of those that do win, persistence is very low. According to SPIVA, only 3.7% of large-cap funds, 5.79% of mid-cap funds, and 7.82% of small-cap funds maintained top-half performance over five consecutive 12-month periods. Random expectations would suggest a repeat rate of 6.25%. Thus, for those managers that do outperform their benchmark, it is hard to decipher whether it was due to luck or skill.
  4. 4.     Fees Matter: On average, active US equity mutual funds are 7 to 8 times more expensive than passive funds of a similar asset class.[2] A 1% difference in overall cost over the course of 30 years equates to a 25% reduction in accumulated wealth if higher fees are not accompanied with higher returns. Morningstar has determined that fees are “one of the only reliable predictors of success.”[3]
  5. 5.     Long Term Market Returns are Attractive to Begin With: From 1928-2015, the S&P 500 has delivered a 9.27% annualized return. This equates to an investor doubling their money every 8 years or about 5 times over their working life (40 years). From 1928-2015, a globally diversified portfolio with a tilt towards small cap and value stocks has delivered an 11.49% annualized return.[4][5] This would equate to an investor doubling their money every 6 years or about 7 times over their working life. For example, a $30 million pension would have grown to $264 million over a 20-year period with these type of market returns (assuming no additions or withdrawals).[6]
  6. 6.     Better Diversification: Diversification reduces firm specific risks that do not compensate investors with additional return.[7] Most passive funds hold hundreds to thousands of individual securities at a relatively low cost.[8] Passive funds are available for most asset classes around the world, which allows investors to build a globally diversified portfolio.
  7. 7.     Better Risk Management: Passive funds allow for better control over risk in a portfolio because we have a better expectation of future risk and return. Investors can structure their asset allocation in a way that maximizes their return for a given level of risk (i.e. Modern Portfolio Theory). Passive funds can also be utilized to target known risk premiums in the market that have been shown to compensate investors with additional return.[9]
  8. 8.     Better Understanding of Risk: The expected return of any given company is tied to the risk associated with that company. The riskier the company, the higher the expected return for those who are willing to bear that risk. The “best” companies don’t necessarily make the best investments. A study conducted in 2010 confirmed that companies with the highest “Fortune” ratings (admired) underperformed those with the lowest “Fortune” ratings (spurned) by 2.31% per year over the 24 year, 9 month period ending 12/31/2007.[10]
  9. 9.     Embrace the Right Types of Risk: Not all risks are created equal. There are 3 known risk premiums associated with higher expected returns:[11]
    1. a.      Market – (inflation, recession, wars, etc.)
    2. b.     Size – (small companies versus large companies)
    3. c.      Relative Price – (value stocks versus growth stocks)

The Fama/French US Small Value Index has outperformed the Fama/French US Large Growth Index by 4.26% per year from July 1926 to September 2016.[12] Investors can structure passive portfolios that target these drivers of expected stock returns.

10. Peace of Mind:  Once you do adopt a passive investment strategy, you can finally invest and relax. Markets will act as an ally to constantly price risk based off of news to ensure that investors are expected to earn a fair return. Because short term market movements can be characterized as random at best, investors can tune out of the daily noise and focus on the long game.

 



[1] Data based on the Center for Research in Security Prices (CRSP) Survivorship Free US Mutual Fund Database

[2] Based on active US equity mutual funds. The average for active funds is 0.77% and 0.10% for passive funds (http://www.wsj.com/graphics/passive-investing-five-charts/)

[3] http://www.investmentnews.com/article/20160819/FREE/160819916/fees-matter-most-when-it-comes-to-active-management-performance

[4] Based on historical performance of IFA Index Portfolio 100

[5] Small cap and value stocks have been shown to be higher sources of expected return.

[6] Very simplisitic analogy, but shows the attractiveness of just accepting market returns.

[7] Idiosyncratic (firm specific) risk is not expected to compensate investors because investors can remove that risk from their portfolio for free (without sacrificing return)

[8] For example, the Vanguard Total World Stock Index holds 7,627 individual companies around the world

[9] Market, size, and relative price (value). These factors were most adequately reviewed in Fama/French’s 1992 paper, “The Cross Section of Expected Stock Returns

[10] Meir Statman and Deniz Anginer, "Stocks of Admired Companies and Spurned Ones," Santa Clara University Leavey School of Business, Research Paper No. 10-02 (2010).

[11] Known dimensions of expected return most thoroughly addressed in Fama/French’s 1992 paper “The Cross-Section of Expected Stock Returns”

[12] Best estimate of the value of incorporating a small/value tilt in a portfolio

 


About the Authors

Tom Allen

Tom Allen

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

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.