Recently Seeking Alpha contributor Kevin Wrotenbery wrote an article entitled "Why I'm Not a Passive Investor." I thought it worthwhile to explain why I am a passive investor, and why it's likely you should be too. Before beginning, it's important to provide a few definitions of what is meant by passive investing, at least what I mean by passive investing.
First, it's important not to confuse passive investing (or indexing) with the exclusive use of an S&P 500 Index Fund (like VFINX or SPY) or even a total stock market fund like (like VTSMX, VTI, or IWD). At the very least, investors should also own equities in the developed markets and emerging markets as well.
Second, there are passively managed funds that aren't index funds. A perfect example is the Bridgeway Blue Chip 35 Index (BRLIX) is a passively managed fund that buys and holds the largest 35 stocks by market cap and equal weights them. There's no manager deciding which stocks to buy and no manager trying to time the market. But, there's no index of such a group of stocks. Fund families like Bridgeway, Dimensional Fund Advisors (DFA), Wisdom Tree, AQR, and others, provide a group of passively managed funds. (Full disclosure: My firm Buckingham recommends Bridgeway and Dimensional funds in constructing client portfolio.) However, most of their funds have no indexes they are benchmarked against. Each of them creates their own definitions of eligible securities, rules that define the stocks that are eligible to be bought, rules on when they should be sold, and strictly follows the rules. For example, a fund might buy all the stocks that are in the bottom 30 percent as ranked by book-to-market ratio or price-to-earnings ratio. There's no manager overriding the rules and no market timing, with the funds always fully invested in the asset classes they are trying to represent.
Third, you can be a passive investor and have a different allocation than the market. A passive investor might have allocations to small stocks, small and large value stocks and REITs that don't mimic the allocation of the total market. Clearly that would be an "active" decision to not look like the market. However, if it's implemented using passively managed vehicles - the investor is being passive accepting the returns of the asset classes in which they invest.
Fourth, being passive doesn't mean doing nothing, as many think. To be passive you must not only use passive vehicles, but you must also rebalance your portfolio to keep the asset allocation you decided was the right one from drifting due to market movements. That means that over time you will regularly be selling the outperforming asset classes and buying the underperforming ones. And for taxable accounts, you should also be engaging in tax loss harvesting when appropriate.
Fifth, to be passive both you and the vehicles you invest in must be passive. So if you use actively managed funds, even if you never trade, or rebalance, you're an active investor in the same way as if you were the one doing the trading and market timing instead of the fund manager you hired. Now we'll turn to the reasons why I'm a passive investor.
There's an overwhelming body of evidence demonstrating that active management is a "loser's game." A loser's game is one in which while it's possible to win, the odds of doing so are so poor you shouldn't try unless you place a high value on the entertainment value. My book, The Quest for Alpha, presents the evidence showing that whether we are talking about individual investors, mutual funds, hedge funds, or venture capital, the majority of those playing underperform appropriate risk-adjusted benchmarks. And that's even before considering the impact of taxes, which can create a very large burden for active managers. In fact, Theodore Aronson, managing principal of Aronson + Johnson+Ortiz, LLP stated: "None of my clients are taxable. Because, once you introduce taxes… active management probably has an insurmountable hurdle. We have been asked to run taxable money-and declined. The costs of our active strategies are high enough without paying Uncle Sam."
And while it's true that some active managers do outperform over even long periods, the evidence is very strong that there's no persistent performance beyond the randomly expected. That means you cannot use the past performance of active managers as a predictor of future performance. We see this twice every year when S&P releases its Indices Versus Active scorecards (SPIVA). Each time the results are the same. Actively manage funds persistently underperform and there is basically no evidence of persistence beyond the randomly expected. Even Morningstar admitted that simply ranking by fund expenses provides a better predictor than their star ratings.
The table below provides a demonstration of why active management is a loser's game. It presents the Morningstar rankings of DFA's mutual funds in each of the asset classes for the 15 years ending Friday, February 07, 2014.
Morningstar Percentile Ranking
DFA U.S. Large (DFUSX)
DFA U.S. Large Value III (DFUVX)
DFA U.S. Small (DFSTX)
DFA U.S, Micro Cap (DFSCX)
DFA U.S. Small Value (DFSVX)
DFA Real Estate (DFREX)
DFA International Large (DFALX)
DFA International Value III (DFVIX)
DFA International Small (DFISX)
DFA International Small Value (DISVX)
DFA Emerging Markets II (DFEMX)
DFA Emerging Markets Value (DFEVX)
DFA Emerging Markets Small (DEMSX)
Average DFA Ranking
Over the last 10- and 15-year periods, DFA's funds outperformed 76 percent and 80 percent of the actively managed funds that survived the full period. In other words, there's a large amount of survivorship bias in the data because Morningstar doesn't account for the funds that either did poorly and were sent to the mutual fund graveyard (where their returns are buried), or were merged (and their performance disappears). Accounting for the "dead" funds would improve the ranking of DFA's funds considerably. And, as mentioned earlier, the rankings are based on pre-tax returns.
This demonstrates clearly that passive investing doesn't get you average returns. There's certainly nothing average about outperforming 80 percent of surviving funds. Instead, it gets you market returns in the asset classes to which you want exposure.
As I said, the evidence is overwhelming that passive investing is the strategy that is most likely to allow you to achieve your goals. However, it certainly is possible that you can outperform by being an active investor. And it's that hope that keeps most investors playing the loser's game, even when they keep losing. It's been well documented that no matter whether you ask people if they are better than average drivers, lovers, or investors, humans have a tendency to believe that they are better than average. A perfect example of this is the following quotation from George Sauter, who recently retired from Vanguard where he ran their index funds as well as an actively managed fund. "Like everybody else in this industry I have an ego large enough to believe I'm going to be one of the select few that will outperform." Unfortunately, investors don't live in Lake Wobegon where everyone is above average.
The More Important Game of Life
While the evidence is overwhelming that passive investing is the winning investment strategy, it's also the winning strategy in the far more important game of life. Here's why.
As a passive investor, when I come home from my busy day, I get to sit down with a glass of wine and ask my wife about her day and how my kids and grandchildren are doing. Because I didn't spend my time trying to beat the market, I also got to coach my youngest daughter's softball, soccer and basketball teams. I also read 50 to 70 books each year, do community service, play tennis, and focus on the other really important things in my life.
Investors following an active management strategy spend much of their precious leisure time watching the latest business news, studying the latest charts, reading financial trade publications, and so on. Even if they are among the few who are successful at the active management game of generating alpha (performance above risk-adjusted benchmarks), the "price" of success may have been that they lost the far more important game of life.
The question for you to consider is what are the important things in your life? Is it trying to generate extra returns through active management strategies that require you to "invest" large amounts of your time? Or are the important things in your life time spent with your loved ones, on your faith, your education, your dreams, a worthy cause, teaching or mentoring others? If you don't already know the answer, perhaps this story will help you find it.
Shortly after my first book was published in 1998, I received a call from a doctor. He had been in practice just a few years. He had a wife and a young child, with another on the way. He had gotten caught up in the euphoria of the bull market and the advent of day trading. He had seen many of his doctor friends generate large profits from trading stocks and he thought he should get in on this easy money.
After putting in his typical long day he would head straight for his computer and the Internet. He spent hours studying charts and investment reports and following the chat boards. Within a few months he had turned his small investment stake into about $100,000. Unfortunately, his wife no longer had a husband, and his child no longer had a father. He was now married to his investments. His wife began to seriously question their marriage. Luckily, within a few months he had lost all his profits.
Fortunately, the doctor realized that his original gains were likely a matter of luck and that he had been a beneficiary of a bull market. More importantly, he recognized that he was not paying attention to his family. When discussing this with a friend it was suggested that he read The Only Guide to a Winning Investment Strategy You'll Ever Need. After doing so he called to thank me for helping him find the winner's game in investing, but more importantly for helping him find the winner's game in life. From then on he was going to focus on the important things in his life.