Passive Investing Should Be Norm
By Tom Stabile
Published: February 2011 10:29
It would be satisfying to settle the debate one of these days with a headline reading "Active Management Triumphs over Passive" or "Passive Management Vanquishes Active Approach".
That argument won't be settled, of course, as long as we have active managers - and we always will - that post benchmark-smashing returns. Still, there is a case to be made that wealth management advisers ought to pick a horse in this race and turn the holiday party chatter that I hear from investment professionals into shared industry wisdom, in the same way that "diversify your portfolio" has become a basic tenet.
John Bogle of Vanguard has long made a sober argument: most investors - the people who do not have the means to hire the smartest consultant to pick the finest managers and gain access to their exclusive funds - should not "waste time" chasing top active managers. Instead, he contends, the typical investor should aim to not get left behind when the market advances by investing in low-cost passive funds that track broad indices.
It is not a thrilling premise, and probably isn't the reason most people dive into the markets. And there are plenty of claims from active managers who can show that their strategies beat the indices, at least for some specified period.
But there is a growing body of evidence to show how passive investing, on average, is a "safer" bet. Most active managers simply do not beat the market consistently. In his 2007 book, The Little Book of Common Sense Investing, Mr Bogle argues that the typical mutual fund pales next to the market over long investing periods. In one exercise, he outlines how $10,000 invested over a 50-year stretch using the average net return of mutual funds would garner $145,400, alongside a $469,000 gain from the market itself.
Indeed, years like 2010 make you wonder exactly why investors would "gamble" on active managers, when only a few investing sectors topped standard benchmarks. Mutual fund sector reports issued last month by Merrill Lynch told a tale of few winners. Overall, only one in five large-cap funds beat the Russell 1000 in 2010, though Merrill says 2011 will be better for active managers. One would certainly hope.
Add to that the casual conversations I and several of my colleagues have had with investing pros over the years. Just this season, I twice again enjoyed chats over holiday cheer with asset management and due diligence specialists - folks who pick active managers, or market such investments - where they confided how they invest most of their own money passively.
Despite what their firms sell, and what underpins their jobs, they saw active management as a worse bet than passive versions of many of the same investments. And the explosion of exchange traded fund varieties, they say, is only making the menu of passive options more robust.
Sure, with a fair bit of squinting, it is possible to pick spots where funds have a good chance to top the markets. Small-cap, for instance, often is a good place to look, and unconstrained funds are having a good run.
The bigger idea, however, is that it is high time for broader industry acknowledgement that passive management is a preferable default for most individual investors, and that active management should come with a brighter warning sticker of sorts.
Investing passively should become a basic rule of the road, freeing wealth management advisers to still specialize in helping investors understand when and how to pick active managers so that they can truly add value for their clients.
And it would avoid the darker perception that could take root over time that the average investor is somehow being had.
Tom Stabile is a reporter on FundFire, a Financial Times publication.
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