When it Comes to Investing, Go Passive: A Guide for Smart Investors

by Luis Pablo de la Horra

Setting aside part of one’s income to provide for contingencies seems a matter of common sense. Uncertainty about the future requires sacrificing consumption today, in order to secure consumption tomorrow. From a macroeconomic perspective, it also makes sense: savings allow for capital investments, one of the keys to increasing productivity and producing economic growth.

The sophistication of today’s financial systems enables economic agents to make use of a wide range of assets to put their savings to work and obtain returns. In countries like the US, for instance,  where capital markets are highly developed, shares, bonds and other financial assets represent the preferred vehicles for most savers.

Traditionally, actively-managed funds have dominated the landscape. In such funds, managers try to beat the market (i.e. obtain higher risk-adjusted returns than a given stock index) by cherry-picking the stocks and other assets they think will perform best based on different criteria: fundamentals, growth prospects, macroeconomic factors, etc. Fund managers also decide what percent of their portfolios should be allocated to each kind of asset: stocks, bonds, commodities, cash, etc.

Over the last decades, new investment vehicles have emerged to compete with this well-established businesses. In 1976, Vanguard launched the first index fund. Index funds replicate the performance of a market index, e.g. the S&P 500, the Dow Jones or the Barclays Capital Aggregate Bond Index.

More recently, in 1993, exchange-traded funds (ETFs) were introduced. These funds differ from index funds insofar as they can be traded like stocks.

Both index funds and ETFs are considered passively-managed investment vehicles since there is no manager analyzing the markets in search of companies with strong fundamentals or potentiality to grow.

Instead, a computer takes care of tracking the ups and downs of one or more market indices so that, at the end of the day, the gains or losses that investors will experience will be the same as those of the tracked markets. As a result, management fees are considerably lower.  

Numbers indicate that passive investment vehicles are rapidly gaining in importance: around one third of all assets under management in the US are in passive funds. Yet actively-managed funds continue to represent the first choice for many investors. Is this justified? Evidence suggests that it isn’t.

Numerous studies have examined the performance of active management in comparison with a benchmark, which in most cases is a market index. The results are strikingly consistent: in the long term, active managers tend to underperform the market. Or put differently, there is no point in paying managers for researching the market to find golden eggs: overall, managers barely add any value.

Two main reasons account for this underperformance: the efficiency of financial markets and high management fees.

According to the Efficient Market Hypothesis, share prices incorporate all publicly-available information. This means that financial markets, especially in developed countries, are mostly efficient, i.e. it is extremely difficult to predict price movements and, thus, to beat the market.

One could argue that markets are not totally efficient. After all, if we have learned anything from behavioral finance is that investors are plagued with cognitive biases that prevent them from making rational decisions, pushing them to buy when they should sell or vice versa.

If this is the case, skillful active managers could  take advantage of the irrationality of market behavior and obtain excess returns over the market return.

However, evidence shows that very few managers beat the market in the long term, which should lead us to think that markets are more efficient than one could infer from behavioral finance research.

For instance, over the ten-year period that goes from 2006 to 2016, 85% of managers in the category large-cap funds failed to outperform the S&P 500.

Underperformance is basically explained by the efficiency of financial markets. Yet we must add a second factor: annual fees. Most funds (either passively or actively managed) charge fees that are calculated as a percentage of assets under management.

As pointed out above, passive funds tend to have lower expense ratios because asset allocation is done mechanically. In contrast, active funds charge very high fees to cover operation costs (the buying and selling of assets), management fees, etc.

This has important implications for long-term returns. High expense ratios imply lower profits. If managers can’t even match market returns, as evidence shows, investing in active funds not only does not add extra value, it destroys value.

However, not everyone agrees. In his new book The End of Indexing, Niels Jensen, founder of Absolute Return Partners, argues that a number of structural changes in the US economy will bring about low economic growth in the upcoming years. In this environment, passive investing might not be the best strategy to follow.

A few things should be noted about Jensen’s argument. First, predictions should be taken carefully. The history of economics is full of predictions that never came true: the never-to-happen Great Depression of 1990 (the S&P 500 grew at an annualized rate of 18% over the 1990s) or Greenspan’s 2007 prediction that we were heading towards a two-digit interest rate world due to high inflation expectations are good examples of this.

In addition, passive investing strategies provide some leeway for market timing (i.e. adapting your strategy to changes in market expectations) at a low cost. In other words, passive investing does not mean rigidity when it comes to asset allocation, although one should bear in mind that, the more you trade using passive investment vehicles, the more costs you will incur; exactly what you are trying to avoid by moving away from actively-managed funds.

On balance, passive-investing strategies have shown to be superior in the long term for a majority of investors. This does not mean that one cannot take advantage of market inefficiencies and obtain higher risk-adjusted returns than the market.

Some value investors, like Warren Buffet, have shown that it is possible to beat the market consistently. Yet very few funds do so in the long term. Are you willing to sacrifice a significant portion of your long-term returns for a very slim chance of outperforming the market?

This piece solely expresses the opinion of the author and not necessarily the organisation as a whole. Students For Liberty is committed to facilitating a broad dialogue for liberty, representing a variety of opinions. If you’re a student interested in presenting your perspective on this blog, click here to submit a guest post!

Image: Pixabay

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