the case for passive index investing

8/8/2019 The Case for Passive Index Investing

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Active vs. Passive

Why You Should Own

Low Cost Passive

Index Funds.


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May not be republished or distributed without permission. Seewww.folioboost.comfor important disclaimer.

The Case for Low Cost Passive Index Investing

A well designed buy and hold strategy using low-cost index funds is better than actively

managing your assets or hiring active asset managers.

Do you agree?

What follows is a discussion outlining why I believe it is usually true and is the best approach for

most people.

Fees are More Damaging than You Think

Management Fees are quoted as a percentage of the whole investment. As such, they seem

low. This is very misleading. Instead, you should think of them as a percentage of your expected

after-tax, real (inflation-adjusted) return.

A reasonable assumption for inflation-adjusted returns for stocks over the next 20 yearsis 5%.

If so, every 1% in annual fees or expenses strips away not just 1% of assets, but 20% ofreturns.

That is 20% of what you are trying to accomplish.

PLEASE STOP FOR A MOMENT AND LET THAT SINK IN.

If you include all the costs of professional active management, as you should, most actively

managed mutual funds and investment managers must overcome a disadvantage between

1.25% and 3.5%.

THIS IS LIKELY TO BE 25% TO 75% of YOUR EXPECTED RETURN!

It may be more if you have a balanced portfolio of stocks and bonds.

The numbers get drowned out in the year by year fluctuations, so people rarely think this way.

But they should. The implications are enormous, and its impact can hardly be overstated. It is

even worse for bonds.

To say this differently, if you start with a $1 million dollar portfolio, using straight line

appreciation and an 8% annual market return, after 30 years a portfolio with a 0.2% expense

ratio will be worth about $9.5 million while a portfolio with a 1.5% expense ratio will be worth

about $6.6 million. The sacrifice in wealth is nearly three times the initial investment (before

taxes). Much of this is due to inflation, but it is still staggering. Also, in real life, returns do not
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come in a straight line. The zigs and zags can actually increase the damage of fees when there is

high volatility.

The True Costs of Active Management

The true cost of actively managed mutual funds or professional investment management isusually between 1.0% and 3.5% per year. It is significantly higher than people realize because of

hidden costs.

The true costs of active management come from these four sources:

1. Management Fees (if applicable)These are pretty obvious. Management fees directly eat up a huge part of your real

return. Most funds or managers charge between 0.75% and 1.5% of assets per year.

Some unlucky folks end up paying someone a fee to pick other funds that chargeanother fee.

2. Trading CostsBy definition, active strategies trade more than passive index strategies. Commissions

are so cheap these days that the direct cost isnt usually meaningful, though it can still

add up. Bid/Ask spreads are often more important. For smaller stocks, bid/ask spreads

can often add 0.5% or more to the cost of a trade. In a well-executed passive index

strategy, you trade very rarely and incur almost no transaction costs. Increasingly,commission costs are being waived by the brokerage firms. Index ETFs are subject to a

Bid/Ask spread, but the major ones are usually $.01 per share or less.

3. Market Impact (if applicable)Often ignored, this is the impact on the stock price from large amounts of buying or

selling by a manager. For fund managers who need to move millions or billions of dollars

around, market impact is very real. There is no way around it. It leads to paying higher

prices when buying and accepting lower prices when selling. The impact is especiallylarge in trades of smaller company stocks. This can easily reduce return by 0.5% to 1%

per year for actively managed funds with more than a few hundred million dollars in

assets.

4. Higher Taxes From Turnover (if applicable)


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Passive index strategies using ETFs, managed correctly, buy and hold the most of the

assets for many, many years. In taxable accounts, this defers capital gains taxes and

avoids short term gains. Active strategies usually, but not always, have higher turnover.

The impact can be significant in long time horizons. Actively managed mutual funds tend

to be particularly tax-inefficient.

Adding the four costs together, we see that active management has a built in disadvantage that

usually runs between 1.0% and 3.5% each year. Again, that is likely to erase 20% to 75% of your

expected real return.

Actively Managing Your Own Portfolio

Humans are naturally wired to be overconfident. It helps us keep going. Attempting to beat the

indexes by actively managing your own assets is a tempting idea. Many of the costs I describe

above are eliminated if you manage your own portfolio, which is a very good thing.

Because I dont know who you are, I dont have any basis for estimating the odds of your

success in actively managing your own assets any more than I know if you should try to fix your

own car. Some people are good at it and should do it. But very few people fit into this group.

Most people are simply not good at investment management. For some strange reason most

people think they are better than they really are. They often have a revisionist history and

actually believe that they have done better in the past than they have.

I have no idea why so many understand they cant beat a chess master or a great poker player,

but fail to recognize that they lack the skill required to beat the market.

Based on my experience seeing thousands of portfolios being managed by individual investors, I

would say 80% of them are inappropriate for their goals. Worse, many individuals will cause

major damage by increasing or decreasing equity allocation at the wrong time or by chasing hot

sectors. Most individuals are not equipped to understand risk management and tend to get led

down the wrong path by the emotions of fear and greed.

All That Matters is Results

You hire an investment manager because they have the skill to beat the market, right? But mostdo not. To simplify greatly, the overwhelming majority of evidence suggests that over time

most managers tend to lag by roughly the amount of their fees. This makes perfect sense.

Therefore, to help make the point, I quote a study from Standard & Poors, who does a pretty

good job at measuring this kind of thing:


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Over the last five years (ending with 2009), the S&P 500 has outperformed 60.8% of actively

managed

large-cap U.S. equity funds; the S&P MidCap 400 has outperformed 77.2% of mid-cap funds;

and the S&P SmallCap 600 has outperformed 66.6% of small-cap funds.

The results for fund managers are even worse for the previous five year period. This means ifyou look at a ten year period, more than 2 out of 3 funds lagged.

You can see the rest of the S&P report at this ridiculously long URL if you are interested:

http://www.standardandpoors.com/servlet/BlobServer?blobheadername3=MDT-

Type&blobcol=urldata&blobtable=MungoBlobs&blobheadervalue2=inline%3B+filename%3DSPI

VA_Year_End_2009.pdf&blobheadername2=Content-

Disposition&blobheadervalue1=application%2Fpdf&blobkey=id&blobheadername1=content-

type&blobwhere=1243661573064&blobheadervalue3=UTF-8

Whatever you look at, most evidence suggests that 60%-70% of active managers will lag over 5

or 10 year periods. More importantly, it is very difficult to pick ahead of time the ones that

dont. This has been the case for a long time.

Why do Most Active Managers do so Poorly Over Time?

Mostly because of fees. It is simple to understand if you look at the math.

Lets say an active manager has a tracking error with a standard deviation of 10%. This means

about two-thirds of the time the managers performance will be within 10% of the benchmark.

This is actually a pretty aggressive manager, most stay closer to benchmark.

No manager beats the benchmark every year. Sometimes they lead, sometimes they lag.

If our manager has a normal distribution of returns, the standard deviation of annualized

tracking error over N years is will be 10%/the square root of N.

After 25 years, for example, this would be 10%/5% = 2%.

This means our manager, who seemed pretty aggressive at first, will probably have annual

returns within 2% of the benchmark after 25 years.

You can see how hard it now is to overcome a fee of say, 1.5%, coming out each and every year.

It gets more difficult when you add in other expenses and market impact. The manager would

have to be either very good or very lucky.
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Based on the math, because of fees and expenses, only a small fraction should outperform.

Indeed, history confirms this. Math is nice like this.

To be fair, remember that even well constructed passive strategies have fees in the 0.2% range

and they will lag by roughly that amount. But 0.2% is a lot better than 1.0% to 3.5%.

Risk Piled on Risk

Another compelling reason to stick with passive indexing is that the additional risk you take

from active management is generally unwanted and hard to plan for.

It is great if an actively managed strategy adds value, but the potential harm from

underperforming is usually of more concern than the chance to benefit from outperformance.

Imagine you put your large cap US equity exposure in the Fidelity Magellan Fund ten years ago

because of its strong track record at that point. At the last month end before I wrote this (April,

2010), despite a great 2009 for the Magellan Fund, you would have lagged the S&P 500 by

about 1% per year over the ten year period. This may not sound like much, but remember what

was covered earlier about the impact on inflation-adjusted return.

Here is the chart from the Fidelity Web page, using the SPY ETF as a proxy for the S&P 500:

Owning this fund turned out to be a big risk for retirement portfolios. It would have helped ifthe fund performed 10% better than the benchmark, but probably not as much as it hurt to

experience the lag. On a million dollars, this is about a $100k difference. You would be pretty

unhappy with yourself if you dropped $100k in Vegas. Why make this bet when you know most

managers will lag the benchmark?


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To make the extra risk acceptable, your confidence level in an active strategy needs to be

greater than 50%, not about 50%.

A quick note about the scenario discussed above. It clearly shows the importance of lower fees.

If the Magellan Fund was not burdened with management fees and market impact costs, it

would have very nearly matched the S&P 500. It wasnt the managers fault. It was the fees. To

be fair to Fidelity, the expense ratio on this fund is only 0.75%, which is low compared to most

actively managed funds. Due to the size of the fund, however, market impact was probably

significant.

Picking the Right Manager Why You Cant Distinguish Luck from Skill

All of this is interesting, but you dont care about all managers, you only care about your

manager or your mutual fund. It should be easy to pick one or two good managers, right?

Unfortunately it is nearly impossible, beyond chance. Why?

Because past returns are not correlated with future returns. Just because a manager has good

past returns does not mean he is any more likely to have good future returns.

Most people are simply incapable of accepting this. But it is true.

There are statistical ways to test numeric results for skill. I am not going to go into the math

here, but some general concepts may be useful.

I highly recommend reading William Bernsteins The Intelligent Asset Allocator. In it, he

presents a fairly compelling argument for why managers with good numbers are more likelylucky than skilled. He uses a baseball analogy, but I did the same before I read his book, so I will

continue with it.

Alex Rodriguez, as much as I dislike him, is a very good baseball player. Since 1996, he has

averaged about 40 home runs per year and has hit just over .300. There is simply no chance

that this is luck. Zero. Steroids maybe, but not luck he is very, very good. But some players are

lucky. In a 500 at bat season, 10 extra hits equates to 20 extra points in batting average. It is

easy to get 10 extra hits due to luck or lose 10 hits due to bad luck. For the sake of argument,

lets say one standard deviation of lucky hits in a season is 10. Thus, about 17% of average

players will hit at least 20 points above their normal average in any given season just due to

luck. The chances of doing the same over a ten year period drop down to about 1%.

Therefore, we can be fairly confident that a player who hits 20 points above the league average

over a 10 year period is actually good, right? Maybe, but dont get too excited yet. We need to

be careful to determine if we evaluated the player in sample or out of sample. If we pick a

player ahead of time and track him alone for ten years, then he is out of sample and we can feel


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good about our high confidence level. However, if we look at all of the players and pick one of

the ones with the best results after the fact, this becomes an in sample pick and it is much

less certain if it was luck or skill. Even if all the players in the league were equal, after ten years

about 5 of them would be hitting 20 points above average due to luck. So there is some risk in

calling one of them skilled after the fact. He may still just be lucky. This is why there are somany free agent signings that turn out to be too expensive in retrospect.

Ok, enough baseball, back to investments. The favorite tool to evaluate a manager is past

performance. The problem is there is not a positive correlation between past performance and

future performance. If anything, it may be negative. A DFA and Standard and Poors study

looking at mutual funds from 1970 1988 shows that for each five year period starting in 1970

(then 1975, 1980, etc.), the top thirty funds went on to lag the S&P 500 in the next five years. I

couldnt find an update of the study, but my guess is the results would be even worse if it were

extended. Definitely the hot funds of the late 1990s were among the worst of the early 2000s.

One other cute stat the first 22 Morningstar domestic equity Fund Managers of the Year

since 1987 have, on average, gone on to slightly lag their benchmarks after winning the award,

as of the end of 2009.

It is necessary to be a bit cautious about these kinds of studies because they may be data-

mined to prove a point. Still, most evidence suggests that strong manager performance is not a

predictor of future outperformance. This makes sense logically because most managers have

biases. As a bias goes in and out of favor, the manager will have good and bad performance

periods.

If you look in sample, of the roughly 10,000 mutual funds, assuming a 50% chance of

outperformance every year, about 5 of them should outperform each and every year in any

given 10 year period. This is probably about what happened in the last ten years, though I am

not even aware of this many. Bill Millers Legg Mason Value Trust had the most famous streak,

which actually beat the S&P 500 for 15 straight years, through 2005. This is pretty amazing.

Then again, he lagged in 2006 and had a terrible 2008. As of this writing, the ten year trailing

return of the fund lagged that of SPY badly enough to seriously damage any retirement plan.

Given that most investors only pile into a hot fund after the fact, my guess is most people who

have invested in this fund wish they never heard of it.

What if you find the Alex Rodriguez of fund managers? Occasionally, you will come across a

manager with numbers that seem beyond luck. Unlike baseball, investment managers can

increase or decrease their risk level. Often, it is worth it for them to take huge risks in order to

potentially get huge returns and then attract a lot of assets and get rich. It is not their money at


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risk so if they fail they can simply close the fund and move on. Be skeptical of abnormally high

returns from funds.

My goal here is not to bash active fund managers. It is only to suggest that past performance is

not a good indicator of future performance. This is almost impossible for most people to

accept. Please try.

Are any managers skilled? There probably are a small number of managers out there who have

some skill and are more likely to outperform than underperform. The problem is it is very

difficult to know which ones simply by looking at returns. Unfortunately, it is difficult to run a

statistical analysis on any one manager because they only live once and it is hard to separate

out the luck factor.

Also, keep in mind that the returns you see from fund managers are highly subject to

survivorship bias. If a large fund family has 25 funds and 20 of them have very good track

records, dont assume you have an 80% chance of success with this company. You just dont see

the other 30 funds that had poor records and were closed or merged with more successful

funds. It is pretty easy to manipulate historical performance to make it look good.

Market Timing?

What about the managers who will get you out of the market when things are bad? Some

managers sell the ability to actively shift asset allocation depending on market forecasts. In

other words, they are market timing. Conventional wisdom suggests this is a losing game and

most dont even attempt it. There is not enough evidence available to say with certainty if some

people can play it successfully, but most probably cant. If you find someone who wants to

move in and out of different asset classes, just make sure you have a lot of confidence and are

willing to take this risk. If they are right, you will be richly rewarded. If they are wrong, your

long-term plans will be shot to hell. I wouldnt risk it, but there may be a very few people out

there who can add value with market timing. Dont believe anyone who suggests they will miss

every bear market.

Buffet

This is getting long. If you still dont believe, here is a quote from Warren Buffet at the 2007

Berkshire annual meeting:

A very low-cost index is going to beat a majority of the amateur-managed money or

professionally-managed moneyThe gross performance may be reasonably decent, but the

fees will eat up a significant percentage of the returns.

A Blessing and a Curse


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Despite all of this, many people will be better off hiring active investment managers because

they are unable to properly implement and maintain a passive index fund strategy on their

own. One of the major benefits of index funds is also a curse for many people. Because they are

so easy to trade, it is easy for investors to get caught up by fear or greed and veer away from

their strategy, often with catastrophic results.

There is nothing wrong with accepting that you should not manage your portfolio and paying

the cost of someone who is qualified to do so. It is a high cost, but still worth it for many

people. Remember, however, that many active mutual funds can just as easily be traded as

ETFs. Numerous studies have shown that most mutual fund investors buy and sell at bad times

and actually perform worse than the funds they invest in over time. If this is your reason for

using actively managed funds, try to find an advisor who will communicate directly with you

and prevent you from hurting yourself.

the case for passive index investing

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