Passive Investing Doesn’t Exist
December 12, 2016
By Resnick Advisors
If you’ve been following the financial news, you are probably aware of the flight of capital from actively managed investment funds, in which fund managers research and pick individual companies in which to invest, to passive investing in index funds or ETF’s (Exchange Traded Funds), which are simply investments conforming to a particular market index or sector. Once an index fund manager assembles the stocks that represent the respective index or sector, their only responsibility is to track that target. We believe that, over time, investors will realize that there is nothing passive about passive investing, and they will be faced with the same headaches as active investors (i.e., monitoring results and rebalancing portfolios) without the potential upside of actively managed investment funds.
There are some big advantages to passive investments (index funds and ETF’s), one of which is that they generally cost less than managed funds, which charge for the manager’s stock-picking expertise. The Vanguard 500 Fund charges .05% – managed funds can charge more than ten times as much, which will negatively impact net return.
Index funds often perform better than most managed funds. For example, if you’d bought the S&P 500 10 years ago you’d have done better than 63% of all the managed funds, according to The Wall Street Journal article “The Dying Business of Picking Stocks” 10/17/16.
Thus, it seems a no-brainer to simply invest in passive funds because:
- It’s simpler – no researching of stocks or fund managers.
- It’s cheaper – passive investing fees are generally lower.
- The returns are often better than those of many active fund managers.
But the easy way is not always the right way. With a little bit of effort, it’s worth building into any portfolio the upside of quality active management.
Let’s start with simplicity. Theoretically, you can opt out of all investment decision-making and “buy the market” – that is, invest in an index of all publicly traded stocks. You could, for example, by the Vanguard Total Market Index. Unfortunately, this index excludes exposure to Foreign Developed and Emerging Markets and provides no flexibility to properly weight mid and small companies into the mix.
Moreover, most investors will buy particular indexes based on their view of the economy – a small-cap index, the NASDAQ, specific industry indexes and so on. And when they are making those decisions, they are no longer passively investing. Indeed, one can (and probably should) build a balanced portfolio of passive funds, a strategy which, by definition, involves active investment decisions.
- Do you use ETF’s or index mutual funds? Each has its advantages. An index mutual fund is priced once at the end of each trading day. An ETF, on the other hand, is more flexible. It trades like a share of stock and is therefore priced constantly throughout the day. If an investor wants to, he can write options (puts and calls) on ETF’s, even though that does not sound very passive. Also, there are a lot of ETF’s competing for investor dollars, and some ETF’s end up closing due to lack of funding – and, when they do, you might end up, at the manager’s discretion, with the individual shares that make up the ETF instead of cash.
- On which investment area do you want to focus? At the most basic level, a well-diversified portfolio should include large, mid-sized, small, and non-U.S. companies – each with its own index – which themselves don’t move in concert. For example, in 2010, the Russell 2000 was up 27% and the S&P 500 was up 15%. In 2014, the Russell 2000 was up 5% and the S&P 500 was up 14%. Over the last 15 years, the S&P 500 annual return was 4%, while the REIT index grew at 12%.
- Not all indexes are created the same way. Do you want a cap-rate index (companies with higher valuations count more than those with smaller market caps), or do you want an equal-weight index? The S&P 500 is market-cap weighted; an equally-weighted version would include the same dollar value for each of the 500 companies. When might you want one or the other? Unfortunately, there is no pattern to equal-weight indexes outperforming or underperforming cap-weighted indexes. Measuring performance over varying periods of time yields different results.
- A note of caution on index tracking – there is no safety net. The manager cannot move to cash as an active manager can. If you were in a passive S&P 500 tracking fund, you would have lost 38% of your investment in 2008.
And it’s also not true that index investing is always cheaper than managed investing. While the Vanguard 500 Fund charges .05%, there are other S&P 500 funds that charge 1.51%, according to The Wall Street Journal article “Don’t Pay High Fees for Index Funds” 5/3/13. Managed funds, too, range in price – from 0.11% of your invested dollars to upwards of 1.75% – with very little correlation between the prices they charge and the returns they deliver. For example, Yacktman Focus Fund outperformed the S&P 500 by 50% over 10 years (thru 8/31/16 per Morningstar). Net of fees, a $10,000 investment in Yacktman Focus 10 years later became $28,165 as of 8/31/16 date. The same investment in the S&P 500 would have netted $21,120 over the same period. It’s worth a bit of research to find these star performers.
One last issue involves the nature of the index. It is our opinion that the less efficient or more complex an investment sector or index is, the easier it is for an active manager to beat the index. For example, the MSCI EAFE (an index of large and mid-cap securities across 21 developed markets) was outperformed by 43 of the 45 foreign stock funds listed in the Morningstar Fund Investor monthly publication for the 12 months ended 8/31/16. To us, it makes no sense to use an ETF or index in this very important investment space.
In short, we think investing in indexes can be a good idea, but don’t fool yourself into thinking that it’s an entirely passive endeavor, or that it’s a one-stop investing solution. In our opinion, a combination of indexes and active investing would be the best approach. Also, a proper asset allocation is as important as (or more important than) the choice of active vs. passive.
As always, we would be happy to discuss any of this with anyone who would like to give us a call or send us an e-mail – email@example.com.