In Investing, You Get What You Don’t Pay For
— John C. Bogle Founder and Former Chairman, The Vanguard Group
Even if you have only just started on your investing journey, you will probably have come across the terms active and passive investing. But do you know what they mean?
Maybe you already have some investments - do you know if they are actively or passively managed?
There's also another investing strategy that you might not have heard so much about - evidence-based investing.
Here's a brief outline of each type of investment.
ACTIVE INVESTING
Active investing means that a fund manager will create a portfolio of funds for you with the objective of BEATING the market.
They will strategically build this portfolio based on research and will make case by case decisions on whether to buy, sell or hold in the belief that these companies or sectors are going to grow at a faster rate than the rest of the market.
Active fund managers will frequently buy and sell stocks and every time they make a trade, this incurs fees and charges which is taken out of your investment.
In addition to the frequent trading, your fees will also need to cover a team of people who are inputting into the portfolio selection which could include any combination of company analysts, industry analysts, market analysts, financial analysts, data scientists, commodities and foreign exchange experts and economists.
The overall aim is that the above benchmark returns will justify the higher fees.
But paying higher fees do not guarantee good returns.
Actively managed fund performance has struggled over the last 10 year period.
For the last 5 years ending December 2017, almost 85% of U.S. large-cap funds helmed by managers did worse than the S&P 500, according to S&P Dow Indices data.
If only 15% of fund managers are able to create portfolios that outperform the benchmark index, then it is very difficult for investors to find a good active fund manager in the first place.
Jeffrey Ptak, from Morningstar gives this advice when people ask him what's the one thing someone should look for to identify an active fund that will succeed in the future:
"The short answer is that there isn't any one thing, and that's why, to be blunt, most investors should probably index, not hunt for active funds."
Effectively investors are paying more for worse results than if they had invested their money in index funds.
So what is a simple way to keep your costs low and statistically, beat the returns that a fund manager could get you?
PASSIVE INVESTING
Passive investments are trying to MATCH the market by tracking market indexes such as the UK FTSE or the S&P 500 in the US. Rather than buying individual stocks you are buying all the stocks in that index.
Your fund will mirror the performance of that specific index so when the market goes up so does your investments but when it goes down, your investments will go down too.
As no-one is actively managing the portfolio - there's no need to select individual stocks so you don't pay large management fees, and there is no frequent trading therefore fees can be kept low.
Lower fees means you keep more of the returns.
The increase in index funds has been dominated by Vanguard and iShares and shows little signs of slowing down.
The over-arching philosophy behind passive investing and index funds is that capitalism works, the markets are efficient and therefore buying the whole market will perform better than trying to pick individual shares over a long period of time.
The ease of buying trackers also makes this appealing to every day investors – there are lots of online brokerage services that mean the process is relatively easy and low-cost.
Even Warren Buffett is a fan of passive investing: "Consistently buy an S&P 500 low-cost index fund. I think it's the thing that makes the most sense practically all of the time."
The downside to index funds is that you will NEVER do better than the market.
EVIDENCE-BASED INVESTING
So we have seen that fund managers do one of 2 things: They focus on picking individual securities, or they attempt to mimic the performance of index benchmarks.
Evidence-based investors share some similarities of passive investing - the believe in staying in the market for the long-term and keep costs low but they are fundamentally different in how the portfolios are constructed.
The funds are managed in a rules-based manner and are not reliant on an individual person or management team’s beliefs about the overall market or individual stocks.
They design strategies based on academic research rather than speculation or the need to track commercial indices and build portfolios along the dimensions that drive expected returns.
The building of a portfolio of evidence-based funds expands upon the benefits of index investing while minimising some of its potential negatives.
If you want to know more about evidence-based investing, then schedule a call with me.