“(One of) The Most Powerful Ideas in Investing”

active-vs-passive-investing-300x166 4In the last fifteen months, $215 billion has moved out of actively managed mutual funds into passively managed index funds and Exchange-Traded Funds (“ETFs”).  It’s possible another $2.5 trillion will migrate out of actively managed funds in the next decade.  Noah Smith in Bloomberg View last week suggested this transition may be “the biggest story in the finance industry during the past decade; larger than the 2008 financial crisis.”  In fact, Mr. Smith titled his article “The Rise of the Most Powerful Idea in investing.”

There are five major reasons astute investors use passive investments for mature markets, such as most equity and fixed income asset classes:

  • The “Efficient Market Hypothesis,” an investment theory for which Eugene Fama won a Nobel Prize, states that it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. As a result, it should be impossible to “outperform” the overall market through expert stock selection or market timing.
  • Modern technology allows index mutual and ETFs to construct portfolios that track indices closely and inexpensively. Some index funds have an operating expense ratio of .05% or less.
  • In general, actively managed funds over time have underperformed. It’s pretty simple math. Investors in actively managed funds are paying higher operating fees and sometimes front-end loads and marketing fees as well.  All in all, some actively traded funds have expenses over 1.5% per year, while a similar exposure in the markets using passive funds could cost .35% or less.  People trying to beat the market are likely to lose, since they tend to be trading on stale information, while paying higher fees at the same time. On average, the 1% or more of costs result in underperformance of a similar magnitude.  Over time, this has a huge negative impact on wealth creation.
  • Low interest rates are producing lower returns which make investment costs more noticeable and painful, pushing people toward low-fee passive investment vehicles.
  • The new “Fiduciary Rule” issued by the Department of Labor has brought more public awareness to the difference between brokers and Registered Investment Advisers (“RIAs”) like DWM.  Many investors previously thought that any financial advisor was a fiduciary and hopefully looking out for the clients’ best interests.  When, in fact, some brokers were looking out for their own best interests, selling actively managed funds that produced more income for the broker, while reducing the potential performance for the investor.

We may now have hit a real “tipping point” in the “debate” over actively managed vs. passively managed investing.  In the latest sign of the change, yesterday Charles Schwab & Co. announced it is taking mutual funds with sales loads off its shelves.   These “Class A Load Shares” have become a
“tiny fraction of Schwab’s mutual fund business overall” according to A Company spokesman.

To conclude, while some, such as Mr. Smith, would say that the migration from actively managed investing to passive investing is the “most powerful idea in investing”, we at DWM see this “idea” as just one of the key building blocks of sound investment management.  You regular DWM blog readers and seminar attendees hopefully can recite with us the remaining factors by rote:

  • Creation of an investment plan to fit your needs and risk tolerance
  • Identifying an appropriate asset allocation
  • Structuring a diversified portfolio
  • Reducing expenses and turnover (including use of passive investments for mature markets)
  • Minimizing Taxes
  • Monitoring (by comparison to benchmarks) and rebalancing regularly
  • Staying invested

All of these controllable activities are powerful ideas that can assist you, with the help of your wealth manager if you desire, to add significant value to the management of your investment portfolio and enhance the ability to protect and grow your assets.