People familiar with our investment approach know that after determining the appropriate allocation, we implement our client's investment strategy with "passive" investments. It's good to review what that means and why we take that path.
Passive investing is designed to replicate a market (or market segment) rather than beat it. In essence, this involves owning most or all of the target market, which makes it a broadly diversified, low cost and tax-efficient approach.
On the other hand, active investing is the attempt to do better than the market by picking "winners," selecting stocks or bonds (or paying a manager to do so) that will perform best in the future. Most people find this quite appealing - who doesn't want to win?
The first problem with the active approach is arithmetic. As a group, the active approach can't win. The basic arithmetic behind this truth was demonstrated two decades ago by Nobel prize-winning economist William Sharpe. Since the market is made up of all participants (active and passive) and the costs of active management are much higher, active returns as a whole must be lower after expenses. It's that simple. In the words of Sharpe, "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."
We know that some active managers do win, however. They are the minority, but why not try to find them?
Finding past winners is easy. Finding future winners can be like finding a needle in a haystack. Plenty of research has shown that historical returns don't offer much guidance. Good performance might be evidence of manager ability, or it might simply be a bad manager that got lucky. A 2009 academic study analyzing mutual funds over more than two decades found no more than 3% of the funds showed some evidence of skill. Many other studies have come to a similar conclusion: many top performing funds seem to get there by pure chance.
And finally, even if we should happen upon a good fund, the rewards for doing so are underwhelming. A 2006 Kiplinger's magazine article touted a list of "25 Best Mutual Funds" - handpicked funds expected to be market-beaters. Of 16 U.S. stock funds on that list, only seven finished in the top half of their category over the five-years ending October 2011 (i.e. worse than a coin flip). One out of four was in the bottom 5% of its category! The average winner beat a simple market index by 0.58% annually, while the losers trailed by an average of nearly 5% per year. The best fund beat the index by 1.76% per year, while the worst fund trailed by 12.7% per year. A strikeout was much more painful than a homerun.
The spoils of the uncommon victory for active management just don't come close to matching the high cost of defeat. Passive investing is a much more consistent way to capture investment returns and put the odds in your favor. Our goal is for our clients to reach their goals, and as "exciting" as it may sound, passive investing is one of the best ways to get there.