We might as well be upfront: the passive vs active investing debate isn’t much of an argument. On one side is a mountain of evidence in favour of passive investing. While on the active investing side is a mountain of marketing money attempting to keep a very profitable show on the road. 

It’s a story not unlike that of the tobacco or oil industries facing down their own inconvenient truths. Where the corporate incumbents deploy cash like nails under the wheels of progress. Slowing down change for as long as possible by befuddling consumers in a fog of doubt and alternative facts. 

That said, what is the case for passive investing?

In a nutshell:

Active investing returns aren’t consistently good enough to overcome their higher costs. Over a lifetime, this means that passive investors will earn higher investing returns than active investors, on average. 

Below we’ll walk through the key passive vs active investing evidence that justifies this conclusion.

What is passive vs active investing?

Passive investors hold entire markets, such as global equities or UK government bonds. The evidence suggests this low-cost, low-turnover diversification across key asset classes is a winning investment strategy for most people. 

Each such market is defined by a benchmark index such as the MSCI World, S&P 500, or FTSE All-Share.

Passive investments such as ETFs or index funds replicate those indexes very efficiently. In doing so they enable investors to hold a whole market like UK equities in a single vehicle.

This makes index trackers the ideal way to implement a passive investing strategy. 

Active investors, by contrast, hold a particular subset of each market they care about. They (or their fund managers) pick the mix of funds, individual shares, or other securities that they believe will do better than the rest. (“Outperform,” or “beat the market,” in the jargon.)

Active investors may also time their trades – trying to stay ahead of current events like surfers riding a powerful wave. 

But active investors can be dragged down by their efforts to beat the market. They may misread events, choose the wrong securities, or incur such high costs that they earn worse returns than if they’d just taken the market average.

Passive investors, meanwhile, accept they do not have the skill to beat the market. They therefore choose low cost index trackers that reliably deliver the average market return, minus the wafer-thin fees necessary to run these funds.  

By investing enough money, into the right combination of assets, for enough time, passive investors aim to achieve their financial objectives by earning the market return. 

Thus active vs passive investing is the financial version of the tortoise vs the hare. Slow and steady wins the race. 

Passive vs active investing evidence

The reason why passive investing is better than active investing largely boils down to costs. 

Nobel Prize winner William Sharpe laid out the mathematical reasons why passive funds prevail.

When you look at the total population of investors:

• Passive investing delivers average returns minus low costs

• Active investing delivers average returns minus higher costs

The lower your costs, the more of your money you keep. The higher your costs, the more your money is diverted to some Ferrari-driving fund manager.

Passive investors beat active investors as a group because both earn the same returns on average – but passive investing costs are lower. (See the Financial Conduct Authority evidence on the damage wrought by fees below.)

Sharpe showed that the total market return is the sum of all investors’ returns. By definition, the market must encompass all investors who outperform and those who underperform:

That sum of outperforming and underperforming active investors is the reason why active investing is a zero-sum game. 

The winning investors earn their gains at the expense of the losers. 

But passive funds stand aside from this ferocious competition. Index funds and ETFs are designed to capture the return of their market. They do this reliably because they own that entire market. They don’t seek to profit from owning a particular slice in the hope of outperforming. 

As a passive fund investor this means you can count on achieving the average market return – less the slim costs needed to run the fund. 

Active investors as a group are similarly left with the same average market return. But crucially they must then deduct higher costs. 

Hence the passive v active investing debate ends in a win – on average – for passive investors. 

Passive vs active investing as explained by Warren Buffett

Investing legend Warren Buffett explains the logic of passive v active investing similarly:

A lot of very smart people set out to do better than average in securities markets. Call them active investors.

Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund.

Therefore, the balance of the universe – the active investors – must do about average as well.

However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors. 

Active investors are betting that they can find a combination of securities that enable them to consistently beat the market. 

They believe they will rank in the set of winners who achieve higher than average returns. 

They do not believe they will fall into the set of losers who inevitably weigh down the results of active investors overall. 

If they thought they were doomed to underperform then they’d buy passive funds and accept average returns. 

Some people are fooling themselves. All active investors must believe they’re above average. But we know it’s impossible for everyone to be above average. 

In fact the evidence shows the majority of active investors overestimate their chances of beating the market. 

Active vs passive investing: why amateurs get fleeced

The competition between professional active investors is fierce. The stakes are sky-high: if you can consistently beat the market then you’ll rake in fabulous wealth. 

Ordinary investors try their luck, too. Picking stocks on trading apps. Perhaps investing in an industry of the future like AI, robotics, or healthcare. 

But remember active investing is a zero-sum game. Winners pick the pockets of losers.

And ordinary investors don’t realise that most of the time they’re competing against huge financial players. They’re kitted out like Mr Blobby on a battlefield stalked by giant terminator droids who use amateurs for target practice. 

Civvie active investors pit their stock tips and hunches against smart-money war machines deploying ranks of quantum physics PhD.s, advanced AI, data connections powered by lasers, terabytes of industry intelligence, and a relentless 24/7 work ethic. 

Some active firms have literally dug through mountains for an extra millisecond trading advantage.

David Swensen, the famed manager of Yale University’s endowment fund, candidly assessed the chances of ordinary investors in his book Unconventional Success:

Individuals who attempt to compete with resource-rich money management organizations simply provide fodder for large institutional cannon.

There’s a reason the finance industry calls regular folk ‘dumb money’.

• Learn what to do if you’re an ordinary investor with no reason to believe you can beat the smart money.

Active vs passive funds: why picking a professional is a losing game

An alternative active approach is to outsource your strategy to someone who promises to smash the market for you. 

Intuitively it seems obvious. Find someone with a good track record, and let them spin your mini-bucks into megabucks. 

Sadly, this doesn’t work either. The long-running SPIVA study shows even most investment industry professionals can’t outperform for long. 

A whopping 62% of active fund managers investing in UK equities failed to beat the market over the ten years prior to the end of 2021.

It gets worse.

• 90% actively investing in global equities failed to beat the market across the same decade.

• 95% of actively managed equities funds investing in the US failed too.  

Some managers do buck the trend for a while. And a few maintain their winning streak for years. They’re hyped like the Second Coming by a finance industry eager for miracle workers. 

But like aging prize fighters, most are brought down eventually. Neil Woodford being the most spectacular crash and burn in recent UK investing history. 

The evidence against persistent active manager outperformance led the FCA to conclude:

It is widely accepted that past performance is not a good guide to future performance. We find that it is difficult for investors to identify outperforming funds. This is in part because it is often difficult for investors to interpret and compare past performance information.

Even if investors are able to identify funds that have performed well in the past, this past performance is not likely to be a good indicator of future performance.

Picking an active fund on the basis of dazzling recent results is like handing your money to someone who just hit the jackpot on a fruit machine. There’s no guarantee they can repeat the performance. There’s many reasons to think they won’t.

They don’t make their money by beating the market

Failure isn’t worth the risk when your financial future is on the line and that’s why we recommend using a passive investing strategy.

This is difficult to credit in the face of active investing propaganda – and even common sense.

So let’s turn again to Warren Buffett, the Sage of Omaha, for a dose of his condensed wisdom:

Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades.

A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.

There are a few investment managers, of course, who are very good – though in the short-run, it’s difficult to determine whether a great record is due to luck or talent. 

Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship.

The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well.

Remember we’re not saying that active investors can’t beat the market full-stop. Some do.

But active investing is like a sea seething with mosasaurs and megalodons. People get eaten for lunch all the time. And it’s rare for even the biggest of beasts to stay on top for long because this is an ultra-Darwinian competition, red in tooth and claw. 

Knowing this, the finance industry long ago realised it’s easier to profit from high fees and the human desire to believe we deserve better than average. 

A UK academic study by Blake et al points to the true beneficiaries of active management:

Although a small group of ‘star’ fund managers appear to have sufficient skills to generate superior gross performance (in excess of operating and trading costs), they extract the whole of this superior performance for themselves via their fees, leaving nothing for investors. 

Passive vs active investments: the importance of costs

An FCA report on the UK asset management industry confirmed the passive vs active fund findings of academics like Sharpe and investing insiders like Buffett:

Active funds for sale in the UK, on average, outperformed benchmarks before charges were deducted, but underperformed benchmarks after charges on an annualised basis by around 60 basis points.

Now, that cost gap doesn’t sound so bad. Which helps explain why many people risk taking the active side of the passive vs active investment bet.   

But the FCA produced this chart to show how much wealth active management can leech during quite a short investing lifetime: 

The graphic compares the ultimate returns (after costs) to an investor in typical UK funds:

• Passive investing returns (red line)
• Active investing returns (blue line)

The passive investor’s returns are 44% higher than the active investor’s.

It’s a tiny discrepancy at first. But the higher fees lever open that 44% gap that’s a trough of City riches.

For many people that could be the difference between enjoying a secure and comfortable retirement versus living in fear of running out of money.

The reality of being on the wrong side of the passive vs active investment cost gap is even worse than illustrated though. 

Your investing horizon could easily last over 60 years when your wealth-building phase is added to your retirement years. 

That’s a long time for high fees to negatively compound against you.

The upshot is that active vs passive fund costs make a critical difference over a lifetime. Do not underestimate them.

Don’t fall for it

If you still find it hard to believe that a multi-trillion dollar industry can largely be based on smoke and mirrors then let’s get a final sense check from Warren Buffett:

The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.

Both large and small investors should stick with low-cost index funds. 

Enough said. 

Take it steady,

The Accumulator

P.S. Many other investing luminaries have spoken in favour of passive investing vs active investing. The Investor has put together a small selection.

There is also much more research available from the academic community that finds overwhelmingly in favour of passive investing.

An interesting starting point is the literature reviewed by the FCA. You can find a list of sources on page 104 and 115 of the FCA’s Asset Management Market Study – Interim Report.

What caught my eye this week.

There hasn’t been much to cheer about recently, so I especially enjoyed Vanguard’s new paper How America Innovates (research, PDF).

In it the authors track how scientific and technical innovation are diffused through different fields, which causes a chain reaction of further innovation.

And they argue we’re at an inflection point where several key discoveries are finally making their way into commercial applications.

This table simplifies how ‘innovation shocks’ in one field are causing ripples of progress in others, to yield new areas of research and application:

Source: Vanguard

The authors conclude it’s all good for productivity – and for the American economy generally:

We now expect U.S. GDP per capita growth to average 2.0%–2.5% from 2020 to 2030, a pace we haven’t seen in decades and a positive development for wage growth, asset returns, and economic opportunity (Davis et al., 2020).

This productivity boom has been bubbling under the surface following the global financial crisis, supported by research in less visible upstream disciplines that needed time to permeate downstream and find their commercial utility.

And while the focus is on the US, there’s reason to be hopeful elsewhere too.

An additional thread in the paper is how distant researchers are more effectively collaborating, and how innovation is thus more geographically diversified.

Globalization and the Internet get the credit, and though the UK has been going backwards in fostering international collaboration since 2016, Britain remains an innovation powerhouse.

What’s more, productivity-boosting commercial applications will become available globally, regardless of nation state blundering.

All together now

Given the culture wars blighting all social media feeds, I was also pleased to see the empirical data showing more diverse teams (by gender and ethnicity) have coincided with greater innovation.

Getting more and different kinds of people doing great work isn’t just about virtue signalling. It means more and varied capable brains coming up with the ideas that we all benefit from.

I’m very interested in innovation, not least as an active investor. But with a shrinking and ageing population, productivity gains are something everyone should care about. Further improvements in wealth and our standard of living – not to mention staving off climate disaster – depend on it.

Summer is winding down. Enjoy a great – but not too productive – weekend.

[continue reading…]

Every year seems weird these days. Maybe it’s all down to the coming singularity.

Certainly 2022’s quadruple whammy of war, drought, inflation, and plunging equity and bond prices has provided enough contrast to please even a late-stage Picasso.

Crops wither while inflation runs wild!

Energy prices soar while portfolios plummet!

Or maybe it’s just the same story of everything running out: water, money, and investment returns.

I had feared tough times were ahead. For example I put wobbly markets and inflation on the agenda in late 2021, flagged underappreciated quantitative tightening in February, and by March urged potential retirees to check their sums ahead of what seemed a nailed-on bad roll of the sequence-of-returns dice.

And in June I – belatedly – warned of rising mortgage costs, too.

Some readers complained this blog was getting too gloomy about markets and the economy.

But if anything I was too bullish about the former, at least in the short-term.

Don’t forget the British Pound is down 15% against the dollar year-to-date before you reply that your subsequently puffed-up US-dominated global portfolio is doing very well, thank you.

Our money doesn’t buy as many US hamburgers as it so recently did – even before it’s been further withered away by inflation.

We voted to be poorer, too

I’ve also continued to remind readers that we’re still governed by the mendacious nincompoops who brought us the most delusional national vanity project since the Millennium Dome.

Every day, Brexit makes Britain poorer, more indebted, and facing higher inflation than where we’d be had it never happened.

The UK economy is an estimated 5% smaller as a result of Brexit.

Remember that’s a 5% shortfall versus the counterfactual every year.

The Treasury will get about £40bn less in revenues annually as a result. The politically neutral Office for Budgetary Responsibility continues to predict a 4% smaller GDP in the long run.

This gap means either taxes and borrowing will have to rise or services will deteriorate compared to a rational world where people didn’t pin their hopes on liars who promised nonsense on buses.

So far, so broadly predictable to all but Barry Blimp.

But please remember this when you hear talk about tough choices during the recession to come. We made things much worse than they had to be.

If you wanted Brexit for political reasons then fair enough, but spare me the financial fairy stories.

It may annoy some readers – which honestly isn’t my intention – but I will never let Brexiteers off the hook for the project’s economic consequences.

Sucker punched

So all that trumpeted, did I imagine consumer price inflation breaching 22% by early next year?

Not on your Nelly.

Obviously I also didn’t foresee a hot war on the edge of Europe with a nuclear superpower.

In fact I thought inflation would be rolling over by now.

Oops!

I’ve mostly expected this because I believed surging prices were much more a result of the on/off pandemic economy and the resultant supply chain disruptions than the Covid support packages that so many countries’ pundits are now fingering for their own state’s high price problems.

I read a lot of company earnings reports, and many of them talked about these difficulties last year.

Of course massive fiscal support that put money directly into people’s pockets and near-zero interest rates that outstayed their welcome – along with home working proving much more productive than most people anticipated – did stoke the inflationary engine.

But it’s the wild swings in supply, demand, and the ability of economies to meet either – as well as surging gas and oil prices in 2022 – that has sent inflation ablaze.

There are lots of ways to show this, from changes in manufacturing output in various countries over the pandemic to the rise and fall of stay-at-home spending as economies shut then reopened.

But this graph of the cost of getting stuff from China to the US gives at least a taste of just one of myriad supply chain shocks to the global economic system:

Source: Global Trade

It’s not just that an importer might have had to pay ten times as much to bring in a container as they did six months previously.

It’s also the multitude of choices that spiral out from these shocks, that cascade to impact other companies’ supply chains.

A particular component of a car assembly, say, that never got delivered. Or, as I was told about last week, a shortage of cardboard due to the online shopping boom during 2020 that subsequently crimped the production of plasterboard which in turn hit housebuilders.

On. Off. On. On. Off. And so on.

No smoke without fire

Until recently – like, last week – the market seemed to agree this inflation had likely peaked. So it was relaxing its expectations for future rate rises from the systemically critical US Federal Reserve.

But Chairman Jerome Powell appears to have kicked such hopes into the long grass at the Jackson Hole pow-wow. And he administered his painful re-calibration via the groin area, to boot.

Meanwhile UK inflation forecasts seem to be rising every few days, with the latest terrifying forecast for energy bills for an average UK household hitting £7,700 a year in 2023.

Clearly this cannot hold. Many people simply won’t be able to pay. But Government action to do something about it will be yet another intervention with a high price tag.

Debt or taxes – or both – will have to rise to pay to offset at least some of the pain. And with UK government bond yields higher, financing state borrowing is getting much more expensive.

I still believe we should make the most of this energy crisis with a war-footing effort to cut energy use, insulate homes, and ramp-up investment in renewables and nuclear.

Simply subsidizing high energy bills will do nothing about any of that.

Incidentally if even this year’s extreme weather globally hasn’t been a wake-up call for you, then feel free to unsubscribe from Monevator from the comfort of your golf club’s air-conditioned Blimp pen, unless you’re (commendably) open to repeatedly hearing alternative points of view. (Also long known as the truth in this particular case.)

Environmental crisis is the biggest threat to our long-term wealth. I won’t be piping down.

Little savings vs big savings

To return to where we started, let’s conflate the water shortage we’re experiencing now with the predicted money drought to come.

We need to make big savings when it comes to both money and the wet stuff.

Yet most personal finance – including much on Monevator – is of the fix-the-leaks flavour.

For instance, you can:

• Review and prune your regular outgoings.
• Ensure you’re getting the best interest rate on your cash.
• Wear a jumper inside until December and keep the heating off.
• Consider remortgaging to a cheaper deal.
• Start a low-effort side hustle.
• Do 101 other little things to save money.

Most of these things individually won’t move the dial much. If you’ve been asleep at the wheel for a few years then you might make some big savings if you come off a standard variable mortgage rate. But otherwise we’re talking £10 here, £20 there.

However do enough of these and soon you’re saving £500 a month. Every little helps, to borrow someone else’s intellectual property.

Notoriously however, the water companies are apparently not doing enough to fix their leaks.

Britain’s pipes are said to be leaking 2.4 billion litres a day. But the corporate calculation seems to be that redressing this up-front means huge investment for long-term returns that will only inflate some future fat cat CEO’s bonuses, while doing little to keep water in the reservoirs for now.

So instead, it’s a hosepipe ban. And while nobody much likes them, they are said to cut water usage by 10% at a stroke. Big savings indeed.

It got me wondering what would be a similarly drastic response in personal finance terms?

Maybe:

• Postponing your retirement for a year.
• Selling your second home…
• …or downsizing your main residence.
• Becoming a one-car household.
• Renting out a spare bedroom.
• No foreign holidays until inflation abates.
• Getting a second job.
• Extreme frugality.

Now we’re talking! These sorts of interventions are the equivalent of turning your water-starved English garden over to weeds. They’re a big deal but you’ll potentially save a fortune.

They can compound, too.

If you sell your second home, maybe it’s easier for your family to get by with one car. Energy use will plummet with just the one property to light and heat. You could spend your weekends on a side hustle instead of doing holiday home repairs, making further big savings. If you find yourself with a huge cash surplus you could buy more equities while they’re cheap, boosting your future wealth.

Both routes to saving are valid. All will be highly personable.

If you’re a wealthy 1%-er with a second home in the countryside where you tend to leave the outdoor swimming pool heated most weekends in summer – yes, I know such people – then with energy bills set to quintuple compared to a few years ago, you know what you need to cut first.

For more modest Monevator readers, trying to combine the commute with an old-fashioned weekly shop at an out-of-town discount grocer might be more the order of business.

Where will you make big savings if you need to?

The point is that if the worst-case scenarios come true – inflation running at 22%, interest rates above 5%, the Bank of England’s predicted 18-month long recession, energy bills that could put a child through college, higher taxes, and worst of all rising unemployment – then now is the time to act.

Remember: the first cut is the cheapest.

You do not want to be taking actions under duress. At the very least, start bolstering your emergency fund if you can.

Monevator has a very economically diverse readership. Our subscriber base ranges from students interested in investing to at least the several dozen multimillionaires that I am aware of.

One reader stated in our comments that not even household energy bills of £20,000 a year would see them return to the office to reduce their own costs.

Meanwhile a young reader asked me recently if I thought they should suspend their pension contributions or instead sell their car and walk one hour to work.

These two individuals face very different choices.

Please keep this in mind before you share any overly disparaging opinions in the comments below.

Onwards and upwards, via a bit of downwards

Yes, things could turn out better than feared.

Indeed even now there are reasons to be cheerful.

Joblessness is very low, for starters.

Higher interest rates haven’t crashed the housing market yet – frustrating for first-time buyers but better for most of us than the alternative, at least short-term.

As far as I can tell we haven’t had a truly hugely significant Covid mutation since 2021’s Omicron.

And while I am very far from a Liz Truss fan, at least she seems vaguely interested in being a politician. I’d prefer a rest from this current crop of political pygmies, but for now I’ll take a change.

Even lower stock and bond prices are great news if you expect to be saving and investing for decades to come. The bond price reset is particularly welcome, given the portfolio buffering potential of higher yields. Albeit forecast returns are still deeply negative in real terms.

Personally I long for a few boring years where nothing much happens and the return of drizzle in the autumn.

But we don’t get to choose the weather – whether that’s economic, political, or atmospheric.

Let’s hope for the best but prepare for the worst accordingly.

Are you making any changes to your saving, spending, work, or retirement in the face of the cost-of-living Ragnarok? Let’s us know in the comments below!