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Are you being "passive aggressive" with your investments? Thumbnail

Are you being "passive aggressive" with your investments?

It has been a constant source of debate in the investing world for almost 50 years.  Should you try to beat the market by choosing stocks and actively managed mutual funds or are you better off buying passively managed index funds that track a recognized benchmark like the S&P 500 and achieving “market like” returns?  

Given the recent passing of John Bogle, the founder of the Vanguard Group and the father of the index fund, I thought now was a great time to put the spotlight on this debate and how the rapid growth of passive investing has impacted both individual investors and the major players in the industry.

The concept of passive index investing was first introduced by Bogle in 1976 with the launch of the S&P 500 Index Fund (SPX).  He named it the “Vanguard experiment”, but the concept was widely frowned upon, earning it the dubious nickname “Bogle’s Folly”.  The prevailing view was that indexing was choosing to be ‘average' and who would want to settle for that.  In its first year of operation, the fund generated an uninspiring $11MM in investor deposits.  Thankfully, he had thick skin and an abundance of patience because a little over 40 years after introducing the world to the genius of passive index investing, the fund is now named the Vanguard 500 Index Fund (VFINX) and boasts $441 Billion in assets, as recently reported by Vanguard.  

Why is indexing a good investing strategy?

The general premise with indexing is (1) the vast majority of professional money managers lag their benchmark (net of costs) and (2) even those that outperform for a few years are unable to sustain that advantage as the observation window increases.  A recent study conducted by S&P Dow Jones Indices shows that over 1 Year, 5 Year, and 10 Year horizons, approximately 85-90% of active fund managers underperformed their benchmarks.   Also noteworthy is the fact that the professionals had similarly poor results whether they were competing against the S&P 500 (Large caps) or the Russell 2000 (Small Caps) or anywhere in between.  This debunks the theory that there is more opportunity for active managers to find “diamonds in the rough” in small caps since these firms don’t have as many analysts following them as do household names like Google, Home Depot, and Disney.  Click HERE to see the summarized data by each asset category.  

Aside from these already gloomy prospects of actively choosing and beating the market, one also has to consider the additional impact of survivorship bias.  When comparing an active fund against an index over 10 years, the active fund needs to have been in existence for the full 10-year window.  Many underperforming funds get closed or merged into other funds.  It stands to reason that if all funds that started the race are included in the final results, the active funds’ relative performance would be further dragged down by the funds that in reality didn’t even finish the race.

What are the trends on active / passive investment flows?

According to Bloomberg, as of late 2017, one third of US assets were invested in passively managed funds compared to one fifth a decade earlier.  In the first half of 2017 alone, the net flow from active to passive strategies was approximately $500 Billion.  

Have any active managers truly beaten the market over the long-term?

The most notable story of beating the market is Peter Lynch, the star fund manager who ran Fidelity’s Magellan Fund from 1977-1990.  During the early part of his tenure, Magellan didn’t just beat the S&P 500 index, it trounced it by a full 10 percentage points (18.9% vs 8.9%).  These phenomenal gains took place shortly after the fund launched with assets of $just 7MM.  As you might expect, this performance attracted a lot of attention and by 1983 the assets surpassed the $1B mark. The Fund continued to beat the market, albeit at a lower but still impressive 3.5% (18.4% vs 14.9%).  Between 1994-1999, as the Fund ballooned up to $105 billion, the relative performance against the index could not be sustained, and it trailed by 2.5% (21.1% vs 23.6%).  The Fund continued to lag the market from 1999-2016, trailing by 1.8% (2.7% vs 4.5%) as assets dropped dramatically, finishing 2016 at $16MM.  At the end of the day, Magellan is one of just 2 mutual funds that actually beat the S&P 500 over a 46-year horizon (1970-2016).  As impressive as that is, the unfortunate truth is the vast majority of Magellan investors saw returns that lagged the market.  It’s a classic example of money pouring in following strong shorter-term performance only to be disappointed that the future didn’t hold the same result.  If you’d like to read a thorough analysis on both the Magellan Fund story and the broader rationale for passive index investing, Bogle authored “The Little Book of Common Sense Investing” after retiring from Vanguard.  

Is the passive indexing strategy without risk or flaws?  

Of course not.  Investing in the stock market carries risk and if the market goes down you shouldn’t expect your ETFs or index funds to be immune to this exposure.  Even broadly diversified portfolios ebb and flow with the market and it’s this risk that generates the long-term returns you are seeking.  

I think one of the most common mistakes that investors make is they can’t resist the urge to trade their portfolio of passively managed ETF’s.  The 24/7 financial news cycles, affectionately called the “financial pornography industry” by New York Times columnist Carl Richards, can impact ETF investors in the same way it affects investors that hold individual stocks.  New ETF’s pop up frequently and the financial publications release “top 20 ETF’s to buy right now” much in the same way they publish content about “hot stocks”.  

Another challenge with indexing is it does not enable you to participate in water cooler conversations or to be the life of the party as you brag about your Netflix holdings.   Indexing is the equivalent of the dietitian telling you to fill half of your plate with vegetables, 25% with rice/quinoa/pasta, and the remaining 25% with lean protein.  Notice she didn’t say anything about loaded potato skins covered in sour cream and bacon, nor is there room on the plate for a hot fudge sundae.  For clients that show a clear affinity with having a “horse in the race” and who will not be satisfied with a purely plain vanilla index approach, I generally will recommend that they allocate a small portion of their investable assets (5% or less) and give them free reign to choose the stocks or funds that they believe will outperform.  Some call this the “core and explore” strategy while others label this smaller allocation as the Cowboy Fund or even gambling money.  As long as they are comfortable with the potential for these holdings to not only underperform but to outright go bust, I think this approach can be a reasonable compromise to keep the majority of their money invested in the winning index strategy while enabling them to enjoy the fun of trying to spot the next Microsoft.

If you have directed your investment dollars toward passive/index funds, I congratulate you on this decision.   You are avoiding what John Bogle himself characterized as a “loser’s game” by refusing to pay the salaries of highly compensated fund managers and their research departments.  Just remember that the strength of the passive strategy lies in the reality that it entails very infrequent trading.  If you are playing the role of fund manager with your own money and frequently trading your ETF holdings and trying to outsmart your well thought out strategy, you are becoming a “passive aggressive” investor and giving back a fair amount of the advantage gained with your initial decision.  

A classic quote from Bogle in defending his index approach: “Don't look for the needle in the haystack. Just buy the haystack!”

What do other leading investors have to say about index funds and their esteemed founder?  

Here’s what Warren Buffet himself had to say:

"Consistently buy an S&P 500 low-cost index fund.  I think it's the thing that makes the most sense practically all of the time."    

Even Peter Lynch, the one shining star that handily beat the market over an extended time horizon had the following to say:

"All the time and effort people devote to picking the right fund, the hot hand, the great manager, have in most cases, led to no advantage. Unless you were fortunate enough to pick one of the few funds that consistently beat the averages, your research came to naught. There's something to be said for the dart-board method of investing: buy the whole dart board."

Thank you, Mr Bogle for your vision and for your courage to stick with it until the rest of us finally woke up to see the light.  

If you are ready to re-allocate your portfolio to a broadly diversified and cost-efficient ETF/Index strategy but you’re not sure how to do it or which funds to choose, please click HERE to contact me.