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Passive index investing feels wrong

With passive investing, everyday thinking is turned on its head.

Many people find it hard to accept an index tracking fund is the best way for them to invest their money.

And I have every sympathy for them.

It’s easy to forget just how counter-intuitive passive index fund investing really is.

Why would I choose a largely automated fund as the home for my hard-earned savings, merely on the grounds that it’s cheap? What if I am prepared to spend more for a touch of genius?

In most important aspects of your life, you go to the best experts you can afford. You expect superior results as you pay more. It doesn’t always hold, of course, but nobody would choose a burly man with a pair of pliers over a trained dentist on the basis of cost.

Active investing, though, is different. It’s a zero sum game. This simply means that for every winning pound – relative to the market – there must be a losing pound. In other words, winners and losers net out.

Subtract the cost of trading and the high salaries of those paid to choose the trades, and with active investing you’re in the hole and behind the market before you even start.

This means your active fund manager needs to at least recoup his or her costs just to keep up with the market. Research has repeatedly shown that over the medium to long-term, most fund managers don’t do this – which is no surprise, because fund managers are the market!

Average them all up, and they will achieve the same returns as the market, minus costs.

Hence fund managers lag the market on average, despite being paid a fortune and being in the main extremely clever and dedicated professionals.

Which really is weird, when you think about it.

Little costs make all the difference

Investing is also odd because few people think naturally in terms of compound interest. Active managers’ charges of 1-2% a year don’t sound like much when you start investing, but they make a massive difference when compounded over time.

The result of such charges is consistent market-lagging returns from the very firms that set out to beat it.

Which? for example found that only 38% of active fund managers in the UK managed to beat the market in the prior 10 years.

And as we know you know, this is the reason to be in tracker funds. Why risk being in the losing two-thirds?

We aren’t investing to give fund managers gainful employment. We just want exposure to the different asset classes in order to get a decent long-term return for our pensions or other goals.

Since most attempts to beat the market fail, it therefore makes sense to aim for an average return, if it means we can keep costs as low as possible to avoid reducing our returns more than we have to.

Thus the road leads to cheap index tracking funds with charges of less than 0.5% a year, which simply aim for that average return in order to keep as much of it in your hands as possible.

By aiming to be average, you paradoxically do better than the majority of investors who try for more.

Weird!

Top of the drops

Most Monevator readers are familiar with the tenets I’ve just run through. If we were the Boy Scouts, we’d chant some version of them every Tuesday before getting down to business.

But have you tried to explain the case for passive investing to others?

I have, and let me tell you it’s not easy.

I’ve already discussed how most people believe they’ll get a better result by paying more for an expert. It’s perfectly understandable if they don’t know any better.

But even outlining the ‘zero sum’ nature of investing often doesn’t change their view – because most people think they can do things they can’t, like picking a winning fund manager that will be better than average.

This shouldn’t surprise us either. People also think they are better than average drivers, lovers, humorists, and investment blog writers. We’re all deluded.

Emotions come into it, too. Our national sport revolves around a league of football teams dominated by four giants who’ve won nearly everything for many years. And yet up and down the country every Saturday, millions of fans believe something different will happen, and become despondent when it doesn’t. Year after year after year.

Still, even here investing is the funnier old game.

Looking at past results works really well in football. Anyone who studied the past couple of decades for ten minutes would see that supporting Arsenal, Chelsea, Manchester United, or Liverpool is the best bet for fewer tears.

Similarly, you wouldn’t bet against the Harlem Globetrotters or the All-Blacks or Roger Federer in their heyday.  If you see a top athlete or team win one week, you’ve every reason to expect them to win the next.

Yet a good spell for a fund is worse than useless as a guide to its future excellence.

S&P’s latest Persistence Scorecard in the US found that:

“Very few funds can consistently stay at the top.

Out of 703 funds that were in the top quartile as of March 2011, only 4.69% managed to stay in the top quartile over three consecutive 12-month periods at the end of March 2013.”

Read that again. Less than 5% of the top quarter of funds stayed that way for three straight years.

In football terms – in spirit if not in exact mathematics – this is like all but one Premier League team being relegated at some point within just three years.

It’s like Andy Murray winning Wimbledon this year, and this year’s world number #43 winning next year, and then someone we’ve never heard of winning it in three year’s time.

The poor persistence for winning funds gets even worse over the long-term. For example, S&P found that fewer than one in 25 large-cap funds managed to stay in the top half of the tables for five years in a row.

We know why it happens, but it’s still downright contrary to our everyday reality.

Passive parasites

Finally, there’s the contradiction at the heart of passive investing.

This is that passive investors need active investors to be out there hunting for superior companies in order for the market to be efficient.

No active fund managers, no tracker funds – or at least not any that I’d like to invest in.1

To quote Tardas Viskanta of Abnormal Returns:

“The passive investing crowd should be wary of trying to derail active management. The fact is that active managers make the market, to the degree to which it is efficient, efficient.

We can all declaim the hordes of hedge funds out there that are charging their investors 2&20% with little to show for it. But they are the crowd that tries to keep thing from getting too far out of whack.”

Again, this runs totally different to most of our real-world experience.

Doctors do not rely on quacks for a living. And we don’t appreciate a top restaurant only because we are forced to eat cardboard the rest of the week (well, at least not in my house).

Those aren’t great analogies, because I’m struggling to find a real-world parallel. Perhaps quantum mechanics has something similar in the uncertainty principle.

Yes, it’s that weird!

Weird science

Passive index fund investing is logically right, but emotionally and in terms of common sense, it often feels wrong.

I’m not suggesting we abandon it!

But I do think it’s worth remembering now and then just how strange it actually is, particularly when trying to persuade others to the cause.

It’s also perhaps worth feeling just a smidgeon of pride at circumventing your human emotions and apparent common sense to make the leap to passive investing.

It’s logical, after all.

Spock would be a passive investor. Kirk would run a hedge fund.

  1. Theoretically passive funds would still win provided there were at least two active funds trading against each other to make a market, and charging for it. But I strongly suspect the asset class would have become un-investable long before that philosophical point! []

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{ 36 comments… add one }
  • 1 PC August 20, 2013, 9:28 am

    Don’t persuade too many or I’ll have to find a different strategy ..

  • 2 Neverland August 20, 2013, 9:40 am

    The trouble is passive investing is its…passive…and not very interesting

    Watch as this post gets a fraction of the comments that anything about house prices of politics

    The best analogy to passive index investing that I can come up with is property investing, you just literally sit there, only occasionally having to do some repairs or get a new tenant (I’m not advocating property as an investment however for all sorts of reasons)

    Property investors are largely just sitting there waiting for their tenants to hustle to make the rent and for property agents to tell them how much their building is worth or how much more rent they could be getting by renting it to someone else

  • 3 BeatTheSeasons August 20, 2013, 9:48 am

    It also feels wrong to me because market cap passive investing leads you to automatically buy more of a share because it’s got more expensive, and then sell some when the price drops. Buy high sell low is surely not the ideal.

  • 4 Moneyobserver August 20, 2013, 10:21 am

    The best thing is to do both: active and passive investing. The most important thing to remember in any case is to manage your risk.

  • 5 ermine August 20, 2013, 10:35 am

    Just to spoil the party a little bit, to my mind passive investors are still being active in at least one way- the selection of the passive fund they invest in 🙂

    FTSE100, FTSE all-share – emerging markets index funds – Vanguard Lifestrategy all are ‘passive’. Even if everyone chose the latter, what mix of bonds:stocks is still an active choice

    and logically the zero-sum game still applies, you are merely integrating over a larger space. To me it seems that to the extent that passive investing scores, it is in lowering transaction costs massively, both by not paying fund managers to churn, and hopefully in reducing churn.

  • 6 Neverland August 20, 2013, 10:37 am

    @Beat

    I dunno, when I reweight periodically I buy more of the markets that have fallen to rebalance my asset allocation against the ones which have risen

    Eg. last year you would be topping up your allocation to Europe, this year you will be topping up your allocation to emerging markets

    You only have the problem you are citing if you never rebalance

  • 7 Neverland August 20, 2013, 10:41 am

    @ Ermine

    I agree

    Passive investors are still being very active in their asset allocation mix, arguably this is more important than stock picking to long term returns

  • 8 BeatTheSeasons August 20, 2013, 10:50 am

    It’s true that rebalancing between asset classes or regions mitigates the risk by diversifying. However, you still have the problem that within each index tracker you are automatically buying more of the individual companies which have gone up in value, then selling them if they go down.

    For example if you have a FTSE tracker you will own Tesco. You will have sold some shares when Sir Terry Leahy left and the price plunged. More recently you will have been buying as the share price has increased. Some active investors did the opposite and made more money.

    That’s another reason why passive investing feels wrong to me. When Benjamin Graham wrote about buying equal proportions of every company in the index he meant one share in each company, not the weighted market cap method we have with Vanguard, etc.

    I think there was an article about this on Monevator a few months ago.

  • 9 Neverland August 20, 2013, 11:28 am

    @Beat

    I do my rebalancing weighted on share of global GDP at purchasing power parity

    This sounds more grand than the reality of what i do however

  • 10 gadgetmind August 20, 2013, 11:28 am

    @BeatTheSeasons –

    “It also feels wrong to me because market cap passive investing leads you to automatically buy more of a share because it’s got more expensive, and then sell some when the price drops.”

    No it doesn’t, and that’s why cap investing works so well!

    If the price goes up, you neither buy nor sell, you just hold the same number of shares. Because the share price is higher, you hold a larger value, but this exactly matches the market cap ratio.

    Similarly, when the price falls, you just hold.

    No buying, no selling, no dealing fees, no stamp duty.

    The only time you buy or sell is as members enter or leave the index. However, as these are tiddlers, this has a teeny effect in the real world.

  • 11 Grumpy Old Paul August 20, 2013, 11:28 am

    @Neverland,
    You’re absolutely right that, for most people, passive investing is not very interesting but I bet this article gets a lot of comments simply because of the readership of this blog!

    Your average person in the street, until this era of very low interest rates, would never have been interested in an investment strategy which would merely be likely to earn you, in the long term, a few per cent per annum in excess of building society interest rates. Penny shares with the prospect of thrills and spills and huge gains (or losses) are a different matter.

    @Ermine,
    Sorry to agree with you again but I’m afraid I do regarding passive investors being active in, firstly, deciding upon asset classes and allocations and, secondly, selecting suitable implementation vehicles.

    @BeatTheSeasons,
    Sounds like momentum investing to me! There is however a genuine issue during a “bubble”. Consider the late 1990s when people’s exposure to stock markets may have been via a FTSE All Share or FTSE 100 tracker which meant huge exposure to a handful of TMT companies such as Cisco and Vodafone. That’s really when diversification via asset allocation and rebalancing come to the fore, especially having exposure to mid-cap and smaller companies plus income bearing shares. Geographic diversification probably wouldn’t have helped much.

    As has been stated before many times, probably as important as the reduced costs associated with passive investment, is simply adhering to a set asset allocation together with rebalancing rules and thereby avoiding most of the pitfalls arising from human psychology and described in behavioural finance. It doesn’t even seem to matter much what the asset allocation and rebalancing rules are based on a recent article here; this is also counter-intuitive.

    Have the Cass Business School launched their low-cost monkey fund yet? That would be a difficult vehicle to market to Joe public!

  • 12 darkvader August 20, 2013, 1:24 pm

    There is one glaring assumption to call out.

    If there are 20 funds, all of which have beaten the index they track, it doesnt really matter if they fall in the top or bottom quartile in their group. It’s been obvious across many funds where all of them tracking the index having beaten it by a good margin but they fall in the 2nd or 3rd quartile because they just managed 15% above the index while the top quartile managed to gain 30% – so investing in the top quartile fund year on year may be impossible but its very easy to invest in a fund that consistently beats trackers and we dont want to get into that debate of ‘show me what funds these are’

    My personal investment objective, not having failed me yet in over 10 years, is to pick proven funds that are not too volatile which have managed to beat the index year on year every year AFTER counting the TERs and other costs (of course I failed miserably trying to invest directly in shares)

    DV

  • 13 Grand August 20, 2013, 1:58 pm

    I guess I am still new to this all, but I find it quite exhilerating viewing my portfolio at lunch time and seeing how it’s changed based on the noise of the day, or week or month. I wonder if that’s the same view I’ll have in a few years?

  • 14 L August 20, 2013, 2:51 pm

    As part of my employment, I was involved in a project evaluating the performance of a large number of asset management funds in South America from the mid 90’s to the present.

    What did we find? The same as every other report/paper/piece of research. Managers are not able to continually outperform the market or their peers. Their performance is volatile, their strategies are subject to change, and managers come and go. They are subject to other external pressures such as: investors reedeming and therefore affecting their positions; sudden changes in regulatory conditions; and the reality that they have to market and sell their funds to instutional investors which effects their investment strategies.

    Sure, there is reason to consider that the Efficients Market Hypothesis doesn’t necessarily hold. But the reality is, in my/our professional experience, my/our personal experience, the findings of numerous Nobel Prize winners and the findings of a large swathe of the Economics, Finance, Psychology and Business academia, even if you are getting a higher return, you are probably taking on a higher risk.

  • 15 The Investor August 20, 2013, 3:05 pm

    @BTS — I agree that’s a good addition for the ‘feels wrong to most people’ list. But as GadgetMind has explained, index funds don’t work that way.

    They only buy new shares with new money (which is market cap neutral) or when companies enter or leave the index. Otherwise they sit tight. It’s a ‘hold as they go up’ strategy, not a ‘buy more’.

    Moreover, this could be better than neutral. Momentum in share prices exists, and active investors are apt to generally sell their winners too soon. Passive funds have no such flaws.

    @ermine — That’s exactly one of the main reasons passive funds have an edge, hiding in plain sight even in my article. 🙂

    Active finds in aggregate return the market. So do passive funds, by definition. But passives cost less to run. So in aggregate, passive funds win.

    BTS describes passive investing as “less than ideal” but the reality is it’s worse than that. If you have a way to pick either stocks or fund managers that beat the market over the long term, you’ll be better off doing that. That would be the ideal.

    The trouble is that as we’ve heard again in the interesting comments on this thread, very few do.

    Why take the risk of doing worse?

    @Grand — The real test of how much fun it is (or isn’t!) is when the market halves, which it likely will at some point in your investing career. 🙂

  • 16 oldthinker August 20, 2013, 3:07 pm

    @L

    > But the reality is, in my/our professional experience, my/our personal experience, the findings of numerous Nobel Prize winners and the findings of a large swathe of the Economics, Finance, Psychology and Business academia, even if you are getting a higher return, you are probably taking on a higher risk.

    This statement, while undoubtedly true, does not constitute an argument against investing into actively managed funds: a genuine promise of higher returns always comes with a higher risk, so what? What matters in the context of this discussion is that actively managed funds do not outperform the market on average in the first place, so you are not going to get a higher return in medium to long term despite taking a higher risk – unless, of course you get extraordinarily lucky.

  • 17 Grand August 20, 2013, 3:35 pm

    @The investor,

    I just wished I had learnt more about this in 2008. So I could have capitalised on things then. In all fairness when my money halves, how I react will be the real test of character.. hopefully I’ll have a bit of cash to invest when that happens.

  • 18 BeatTheSeasons August 20, 2013, 3:43 pm

    Thanks, GadgetMind and Investor. I’ve learnt something new today, and it feels good to know my index funds are working even better than I thought they were.

  • 19 westy22 August 20, 2013, 4:20 pm

    I hold several low cost passive funds and ETFs but I also have approximately 40% of my portfolio in very low cost ITs such as City of London at 0.45%; Temple Bar at 0.51%; and Bankers Trust at 0.45%. All of these ITs have outperformed their comparable passive funds or relevant indices significantly over 3, 5 and 10 years. OK, I incurred trading costs and SDRT when I bought them but those small amounts have now become insignificant.

    Of course, I am not saying that these ITs will continue to outperform in the future but I don’t see any logical reason why they shouldn’t.

    I’m with Moneyobserver – hold a well balanced mix of both active and passive but, above all, control costs.

  • 20 L August 20, 2013, 6:36 pm

    Must have some memory loss there oldthinker as that is precisely what I said in the opening part of my post…

    L

  • 21 dearieme August 20, 2013, 8:11 pm

    “as the home for my hard-earned savings”: personally I am also on the lookout for a home for my easily-earned savings.

    BTAIM, I’ve decided that the sensible way to discipline myself in passive saving is to dedicate some part – perhaps one eighth – of my funds to an active portfolio. I’ll get fun out of that and find it easier to leave the rest alone.

  • 22 The Analyst August 20, 2013, 9:12 pm

    Great article, Investor.

    I’ve always had a problem with the terms “active” versus “passive” investing as it relates to picking your own shares versus buying a tracker.

    What matters far more, IMO, is how you behave *after* you’ve made the investment. With the ability to trade ETFs any minute of the trading day, for example, I could very well become an active manager of passively-managed securities. Conversely, I could actively build an portfolio of stocks and hold them passively for years.

    Aside from splitting-hairs, I agree that if everyone invested in trackers, price inefficiencies would arise and present long/short opportunities for investors who wanted to select individual securities.

    Also, even if you’re buying a tracker, you’re still buying into a selection system that was once actively constructed. An index must be someone’s brainchild, after all. Witness all the new indexes that have been created out of thin air in recent years to keep up with all the demand for new index products!

    Best,

    Analyst

  • 23 mucgoo August 20, 2013, 9:52 pm

    I’d be interested to see at what point the market would cease to be efficient as turnover percentage decrease.

  • 24 grey gym sock August 20, 2013, 11:14 pm

    ITs have the advantage being being able to use gearing, which magnifies returns (OK, it’s a disadvantage when the market is falling, but we expect it to rise in the long run) – an advantage over any open-ended fund, whether tracker or actively managed.

    that advantage may overweigh the higher costs, at least for the cheaper ITs. e.g. for an IT costing c. 0.45%, you’re only paying about 0.3% more than you would for a FTSE all-share tracker.

  • 25 Neverland August 21, 2013, 9:03 am

    @westy, grey sock

    In the late 80s-90s you could buy investment trust at discounts of up to about a third of their net asset value

    At that time investment trusts had annual fees of c.0.5% a year while unit trusts annual fees were about 1% with the extra 0.5% going to the IFA. Trackers barely existed….excuse my nostalgia

    I remember I bought my first big slug of RIT Capital shares at a discount of nearly 30% to net asset value in the mid-90s

    Discounts have really narrowed over the 20 odd years, especially for UK income trusts, which when I last looked a few months ago, traded at premiums to NAV because dividend income is fashionable right now

    This would have more than compensated for even for paying an extra 0.5% a year in management charges even over 20 years compared to the cheap trackers that exist now

    However, the elimination of the discount is a bit of a one-off trick, rather like the 30 year trend in falling bond yields

  • 26 Luke August 21, 2013, 1:51 pm

    On an *entirely* different note, I seem to be noticing the word ‘weird’ cropping up more and more on this blog. Is it an attempt at some sneaky SEO? i.e. ’10 weird things you don’t know about passive investing’ type articles…

    I await the detailed statistical analysis with weirdly bated breath 🙂

  • 27 The Investor August 21, 2013, 3:33 pm

    @Luke — Erm, no SEO agenda for the word ‘weird’ — which really would be weird — and no article with the title you mention so a bit confused.

    Perhaps you’re weirdly imagining things? 🙂

  • 28 Luke August 21, 2013, 6:07 pm

    Sorry TI – I was referring in jest to the sorts of paid article links that clutter up the web – not a specific Monevator post!

  • 29 The Investor August 21, 2013, 7:56 pm

    Hmm, maybe I should explore the possibilities, Luke. 😉

  • 30 dearieme August 21, 2013, 10:52 pm

    “for an IT costing c. 0.45%, you’re only paying about 0.3% more than you would for a FTSE all-share tracker.” Suppose your IT has a steady 10% discount, and yields about 3%. That’s effectively 0.3%p.a. you can set against costs when you do a comparison with a “fund” or ETF.

  • 31 The Investor August 21, 2013, 11:05 pm

    @TheAnalyst — Great to hear from you and I agree the index is of course an artificial construct. The new rule changes that appear to enable companies to create their own indices to track with their own products are definitely potentially iffy on this score…

    I’m going to explore the active requirement at the hear of passive investing in a future post, it’s really fascinating. Probably needs more a PhD thesis than a blog post though to be honest.

  • 32 Phil August 22, 2013, 1:40 pm

    Hi, a little bit related to this thread, I’ve been reading a bit up on Rob Bennett’s “Passion Saving” site and blog and what he calls “Valuation-Informed Indexing”. While there seems to be a little confusion over people using the term passive and what exactly it entails and to what extent, I’m trying to work out if his approach is similar to your passive approach or is against it!?

    For example are his “stock allocation” changes really just the same as Monevator “rebalancing” the portfolio every year or 2 or a different more active strategy?

    When he suggests share reallocation depending on the P/E ratio as an indicator of the markets over/under valuation does he really mean reducing/increasing exposure to the stock market as a % of your entire asset portfolio (I guess to be held in cash or bonds instead?) or just rebalancing your funds ( in a selling high, buying low balancing of funds as is recommended on this site)?

    I’m sure you may have covered this before but any thoughts/ opions you have on his strategy would be great.

  • 33 The Investor August 22, 2013, 2:11 pm

    @Phil — No, the strategies are not the same. Our rebalancing is a mechanical process whereby you return after some period or level of fluctuation to your original asset allocations. So if you were 40/60 bonds/equities, say, and changes in asset prices changed your allocation to 30/70 after one year, say, then you’d sell equities to top up bonds.

    Rob Bennett’s approach is one of varying your allocation based on the perceived valuation of the market. It sounds quite seductive and I don’t think it will actually do too much harm provided you use it to tweak (not set!) your stock market exposure. i.e. If you used valuation — he uses CAPE, or PE/10 from memory — to determine whether you were 40/60 or 50/50 or 60/40 in shares — then it might have some utility over the long-term. I say that because valuation methods have a very poor short term prediction record, and even over 10 years CAPE only explains about 40% of stock market moves. That’s better than anything else, but hardly a slam dunk.

    The big risk of anything more — i.e. using it for extreme market timing moves — is it could keep you out of the market for long periods of time. If PE10 really does work it’d even out eventually, perhaps (though you’d have to remember you’ve forgone dividends, too, when doing your calculations) but very often you’ll find the windows where you can buy are extremely small. From memory it gave no buy signal in 2009, for instance.

    Rob Bennett used to comment on this site a lot until I got fed up with his “strident” approach and warned him I’d start delete his posts. He carried on (IMHO) so I started deleting them. To his credit he finally took the hint and stopped commenting, which saved us all some time. If you Google “Rob Bennett” in the Search box in the sidebar you’ll see some of his side of the story. Any particular contribution is usually fine to read, but it was the relentlessness of it that took its toll. He’s met a similar fate across a great many sites across the Web, which is a shame as it doesn’t help his message at all, which is perfectly coherent, albeit not one I am fully on board with.

    Personally I think most passive investors will do best with the mechanical rebalancing strategy (adjusting allocations as you age) but I can’t tell the future, and so can’t guarantee it. 🙂

  • 34 Nicolas August 22, 2013, 6:44 pm

    If professional investors have genuine investment skills, then why does random stock-picking beat the market? http://monkeywithapin.com/cass-business-school-proves-that-monkeys-are-better/

  • 35 Phil August 23, 2013, 3:18 pm

    Thanks for the reply, I did search his name in your posts and just wow, that’s some pretty long and epic comments he had! Needless to say just the style and magnitude of his replies have greatly reduced any merit I thought they may hold! I applaude you for being as patient as you were! He just didn’t seem to to get the point 🙂

    Anyway many thanks for your help and your ongoing blogging, it really is very useful for the uninitiated. I have just started up a lifestrategy 80% fund with drip feeding monthly and will see how it goes! In time once I have built up my account and contributions (to perhaps 10/15k mark) and increased my understanding I may become a bit more active and control my own portfolio of index funds rather than soley through Vanguard lifestrategy one stop!

  • 36 Taylor Larimore August 23, 2013, 5:41 pm

    Your excellent article has been posted on the Bogleheads Forum.

    http://www.bogleheads.org/forum/viewtopic.php?f=10&t=122019&newpost=1785130

    Best wishes.
    Taylor

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