Investors receive a plethora of studies, passionately explaining why buying actively managed funds is a better investment choice than buying passively managed funds; and vice versa. The truth is, there will probably never be a clear answer to which is better. The debate is the soap opera of the financial planning world, with no end in sight. This post will make the case for Passive Investing.
Active Managers attempt to beat the market through multiple strategies, while passive managers take a longer-term view and work to deliver market returns. The Efficient Market Hypothesis states that no investor will consistently beat the market over a long period of time, except by chance. Active managers try to disprove this hypothesis every day. Here are three reasons why passive investing may be better for you.
- A recent study in The Journal of Finance shows that “75% of funds exhibit zero alpha (net of expenses)”1. Zero Alpha is a term meaning there is no added benefit to the portfolio over a passive index investment. Believers in efficient markets argue that it is impossible to beat the market. The reality is that active managers can only deliver real value when they beat the market in excess of their fees. Evidence suggests that most cannot, especially over the long term.
- Only a few managers will provide a better return over passive index funds, and it seems to be extremely hard to predict which ones. After only a year, there is little evidence of persistent performance. The managers who do well in one year are no more likely to do well in the following year2. This makes it extremely difficult to select superior active managers.
- Passive investing aims to match the returns of the financial markets, not outperform; which may be a more efficient and pragmatic strategy. Index funds also generally operate with lower costs than actively managed funds. In part because of the cost difference, passive funds have displayed a greater probability of outperforming higher-cost actively managed funds. In addition, passive index funds usually provide better diversification, style consistency, and lower turnover.
Indexing may be your best investment option because the strategy can provide a low cost option to investors. Indexing will not always outperform actively managed funds, but with the costs and efficiency of the markets, consistent outperformance from any one active manager has been rare. Index investing is a less exciting ride, but has higher odds that you will reach your goals on time. Be the Turtle, not the Hare.
No matter how you invest, active or passive – we believe the best investors are goal focused and not market driven. In our opinion, timing the market is not a long-term financial goal; financial independence is.
- False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas The Journal of Finance February 2010
- Five Myths of Active Portfolio Management, Jonathan B. Berk