Rewarding Passive Investors

It’s an age-old debate: Whether active or passive fund investing is the best path to success. For long-term investors, however, it’s tough to ignore the latest data that suggests the passive route is the better option.

Active managers rely on research and personal judgment to determine which securities to buy, sell and hold. The theory holds that markets are not efficient and that by identifying mispriced stocks, investors can outperform the overall market or index.  

Passive managers, by contrast, don’t pick individual stocks. They buy a basket of equities in proportion to their weighting in a predetermined index. For example, there are many mutual funds that mirror the movement of the Standard & Poor’s 500 stock index. The funds fluctuate with the market, and therefore perform poorly in downturns. Historically, however, the market has moved higher over time, offering positive returns for patient investors.

Both strategies have merits. But there are a number of drawbacks associated with active investing that undermine its effectiveness.

Active investors routinely fall short of their benchmarks.  Assuming fees and expenses are 1% of assets yearly, an active manager must outperform the market by a full percentage point simply to match the market return net of fees. That’s quite a challenge. A recent study by S&P Dow Jones Indices found that in the 10-year period ended last December, 82% of large cap stock funds missed their benchmarks. The rate was higher for small cap funds: 88%.

True, that means some active investors outperform the market. But as we all know, past performance does not guarantee future returns. Most portfolio managers don’t have a long enough track record to determine if their returns were the result of skill or luck.  Statistical analysis often requires decades of performance data to determine a manager’s abilities.  Most investors are unwilling to tolerate extended periods of underperformance, often changing strategies when their performance is at its worst.

In a recent study of actively managed U.S. equity funds, the Vanguard Group, a pioneer in passive index funds, found no correlation between a manager’s past five-year performance and the subsequent five-year performance. In fact, statistical analysis shows that even the best managers will underperform more than 30% of the time in any five-year period.

Another concern: Active investing is costlier. Fidelity Magellan (FMAGX), perhaps the best known actively managed fund, has an expense ratio of 0.7%, according to research firm Morningstar. By contrast, Vanguard 500 Index (VFINX), which tracks the S&P 500 stock index, has an expense ratio of only 0.17%.

Finally, keep in mind that investors who decide to forgo stock picking and market timing aren’t totally passive. They still must select the best strategies and funds most likely to meet their goals.

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Christopher M. Meyer, CFA, is an investment specialist and principal at Truepoint Wealth Counsel in Cincinnati. 

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