Let’s talk active and passive. And this is in the context of investments, not time sitting on the couch.
Now, I am a passive investor. One might refer to me as a reformed active investor. It comes from years of listening to an unbelievable number of pitches from actively-managed mutual fund wholesalers and then actually diving into the data of performance.
I should probably give you some quick definitions before diving too far into this topic. And before I forget, passive investing prefers to be called “indexing.” At least last I knew.
When I am talking about active management I am referring to people making tactical decisions regarding investments. The example I use is think of the S&P500 index. 500 largest US companies, right. Well, let’s say an active manager is comparing his investment portfolio against the performance of the S&P500. Maybe within the S&P500 Coke is 2% of the entire value of this index and Apple is 5%. If you invest strictly in the S&P500 you are following these weights (2% in Coke and 5% in Apple). Maybe this active manager thinks this New Coke formula is going to crush the competition and this whole IPod thing is just too weird. So, this manager decides to increase his investments in Coke and go lighter on Apple. If he is right he wins. If not, well, he still wins, which I will touch on in a minute.
On the flip side you have passive management. It is simply following an index. I am sure you know where I am going with this since I mentioned it above. You invest in the S&P500 and just follow how it is laid out. That’s it.
Now, there are a myriad of reasons I am a passive investor. I will share just a few facts with you.
Fees is a big part. And it has to do with the overall performance of indexing/passive investing. The cost for indexes (or indices as some people call it) is substantially lower than actively managed funds. Much of this is due to not having a bunch of expensive fund managers with indexes. Instead, it is a lot of techs making sure the computers are replicating the indexes as closely as possible. Last I knew, computers have no need for yachts or homes in the Hamptons. Here is a quick example. You can buy the SPDR S&P500 ETF index for 0.1%. A comparable actively managed mutual fund can easily cost 1.0%. The lower fees come into play with performance, I promise.
Years ago Warren Buffett offered a bet to any takers within the hedge fund industry. The wager was for $1 million and Buffett bet the S&P500 would outperform a handpicked hedge fund portfolio over a 10-year period of time. One hedge fund manager took him up on it and admitted he lost before the 10 years was up.
I mention this story as a lead to how actively managed funds perform over the long-term. Just in 2021, 80% of actively managed US stock funds underperformed their indexes. Even worse, 99% of large cap growth managers failed to beat their index. For the decade ending in 2021, 74% of actively managed funds failed to beat their indexes for that decade. In case you think this year is going any better for those active managers, well, only 28% of large cap managers beat their indexes last month. The average fund lagged by .76%.
A big reason for this continued failure to beat or even match their indexes is their higher costs. If a large cap fund costs 1% and the index costs .1%, well, the active manager has to outperform the index by at least .90% every year. Less than 1% may seem small, but it is a huge hurdle most cannot overcome.
Another side story. This time with the financial pornography side of my world that is the financial services industry. A couple of months ago there was a big deal that one of the world’s largest hedge funds had returned 32% for its flagship fund for the first half of the year. Now, I did a bit of digging. Had you just invested in the S&P500 for the last 30 years (time frame of this fund), your annual performance would be only 1% less than this flagship fund. And this doesn’t factor in the 2/20 fees that most hedge funds charge (2% annual fee and then 20% of any profits). Oh, and most hedge funds have minimums most investors cannot meet.
The final piece of information is again one of my favorites. The average investor has enjoyed annual returns of 3.6% for the last 20 years. During this same period, a 60/40 portfolio has had annual returns of 7.4% while the S&P500 has averaged 9.5% annually.
At the end of the day I do not believe I am smarter than the market. Yes, there are some professional investors out there who have shown the ability to beat the markets on a regular (but not infinite) basis. However, most fund managers make their money on fees they charge to clients and not their actual investment returns. And, finding these managers who do well year after year is only done in hindsight.
Ultimately, I have better uses of my time. Instead of trying to guess what the market is going to do over the short term I would rather set it and forget it. After all these years I am perfectly fine with being average and just following the indexes. I’ll spend my limited amount of time doing things I enjoy, like being with my family.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.