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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:

  1. It’s simpler – no researching of stocks or fund managers.
  2. It’s cheaper – passive investing fees are generally lower.
  3. 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.

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 – info@resnickadvisors.com.

This material is for informational purposes only. It is derived from sources believed to be reliable and accurate, but it has not been verified by Resnick Advisors nor audited for accuracy or completeness. It does not constitute tax, investment, or other specific advice, recommendations, or projected returns.