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Passive index investing feels wrong

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 [1] 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 [2]. 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 [3]. 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 [4] 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 [5] 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 [6] 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 [7] 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.


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 [8] 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 [9]

To quote Tardas Viskanta of Abnormal Returns [10]:

“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 [11] 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! [ [14]]