“(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.

How Much Are Your ETFs and Mutual Funds Costing You?

Perhaps it’s the new Tony Robbins book that has created this stir, but we’ve gotten a lot of calls and emails lately from people interested in using an independent RIA like us. We’ve also had a lot of questions regarding what type of vehicles we use and the fees involved with them (i.e. Operating Expense Ratios [“OERs”]).

We love taking these questions head on. Since day one, we’ve always preached low cost is better. Transparency about fees and costs is integral to our business. As an Accredited Investment Fiduciary, fees are something we absolutely review and use in consideration of any product.

Furthermore, given the math of compounding, we know (and have given seminars on) the huge benefit that minimizing expenses can have on a portfolio over time. See the graph below:

Expense graph 042915














Here are some Frequently Asked Questions:

Do you use individual stocks?

No. Here’s why: it creates unnecessary company-specific risk. Prudent risk management tells us to avoid company-specific risk and diversify.

What vehicles do you use?

Predominantly, low cost mutual funds and Exchange-Traded Funds (“ETFs”) within our Core Equity and Core Fixed Income models.

Why do you use mutual funds and ETFs?

Each mutual fund and ETF within our Core Equity and Core Fixed Income models provides inexpensive exposure to an underlying basket of securities, hence, providing the investor with great diversification to the multiple market exposures we think an investor needs. These include markets such as large cap, mid cap, small cap, international, emerging markets, investment-grade bond, high-yield bond, floating rate bond, international bond, etc.

How can you tell if a mutual fund/ETF is expensive or not?

Check out their Operating Expense Ratio, which can be found in their prospectus or on Morningstar or Yahoo Finance. OER includes costs such as portfolio management, operating expenses, distribution, and administration. There are some exceptions, but typically an OER under 0.50% is pretty cheap and an OER over 1.5% is pretty expensive.

You said your Core Models are inexpensive. How inexpensive are they?

Our Core Equity model has a weighted OER of 0.34% and our Core Fixed Model has a weighted OER of 0.37%. That compares to the average 1.31% paid to the US stock mutual fund. That is almost 1% in savings. Take a look at the graph above to see what a difference that 1% can make over time. Like Tony Robbins said in his “Money: Master the Game” book: “By simply removing expensive mutual funds from your life and replacing them with low-cost index funds you will have made a major step in recouping up to 70% of your potential future nest egg! How exciting!” How exciting indeed!

I heard ETFs are cheaper than mutual funds. Is that true? 

It’s not black or white. The real question is whether the security (i.e. mutual fund or ETF) is utilizing passive or active management. With active management, there are a lot of added costs: a portfolio management team, traders, rent, etc. Passive management typically follows an index which means a lot of those “active” costs don’t exist. Hence passive management is cheaper.

Most, but not all ETFs, follow a passive management approach. Many, but not all mutual funds, follow an active approach. But that doesn’t necessarily mean that all mutual funds are expensive and all ETFs are cheap. In fact, the mutual funds we utilize in our Core Equity and Core Fixed Models are the ones that follow a passive approach and therefore are just as cheap, if not cheaper, than many of the ETFs out there right now. For example, the Schwab S&P500 Index Mutual Fund logs in at a miniscule 0.09% OER!

So, it’s not the wrapper that makes it expensive or not; it’s the methodology under the hood.

Do you use passive management, active management, or a combination? 

A combination. As a firm, it’s about 75% passive and 25% active. We generally use passive for our Traditional Core Equity and Fixed models, but use active for our Liquid Alternatives model. In most cases within today’s world, one cannot get alternative exposure without the use of an active manager. As the investment world evolves, it is possible that passive management will be employed more and more. But for now, we use what is available. (For more info on why we use both passive & active, see our March 2014 blog).

So why use alternatives at all?

The non-traditional alternative marketplace is an inefficient one. The use of active managers can help exploit these inefficiencies. Studies have shown that adding non-correlated assets, aka alternatives, to a portfolio can improve return and reduce volatility. Alternatives can help cushion your portfolio when there is stress in the traditional markets, thus creating a smoothing out effect on the long-term results of your portfolio. By incorporating a strategy where the majority of the portfolio is invested in traditional equities and fixed income complemented with a minority allocation to liquid alternatives, we can help protect the downside thus making new highs earlier and more often.

In a market environment that may produce only single digit returns, fees play a bigger role than ever. It is critical to use an investment manager like DWM who is looking under the hood and factoring in these costs when making investment decisions. Feel free to contact us for more info on how DWM keeps expenses to a minimum in its clients’ portfolios.