Why I Prefer Passive-Index Investing

by: Lowell Herr

The Efficient Market Hypothesis (EMH) asserts that security prices reflect all available information and that no investor will consistently beat the market over long periods except by chance. Armed with this assertion, the vast majority of investors pay little attention to EMH and as a result make the decision to become active rather than passive investors.

Decision Number 4 in Daniel Goldie and Gordon Murray's book, "The Investment Answer," is the Passive vs. Active decision. Active investors set out to "beat the market" by stock selection, market timing, technical analysis, or some combination of all three. Passive-Index investors are resigned to market returns less expenses.

Passive management carries many meanings so I leave it to Harold Evensky to straighten us out as to what is meant by Passive Investing. In his excellent book, "Wealth Management" Evensky provides this crisp definition that separates index investing from passive investing. "Passive management is the antithesis of active management. Its core philosophical tenet is that by brains, hard work, and technology, a manager cannot, over time and net of costs, beat the system; he can, however, beat most active managers. Passive management is often assumed to be the equivalent of index management. It is not. Index management is a special subset of passive management. A passive manager may make active trading decisions. His decisions, however, are based on information currently available to all investors not on an ability to read between the lines or predict future trends and events. Index management is passive management with the added constraint that the manager does not make active trading decisions."

Armed with the above definitions, here are reasons why I prefer to construct and manage portfolios using non-managed index ETFs with a strong inclination toward a passive rather than an active management style of investing.

1. Passive-Index investing makes good mathematical sense.

William F. Sharpe nails it in his 1991 article, "The Arithmetic of Active Management" where he lays out these ideas. "If 'active' and 'passive' management styles are defined in sensible ways, it must be the case that

a) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and

b) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.

These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division Nothing else is required."

2. Passive-Index investing helps reduce major errors of judgment.

Diversifying investments using non-managed index ETFs spreads risk over many stocks rather than counting on accurate individual stock analysis. The track record of professionally managed mutual funds leaves a lot to be desired. Read Richard A. Ferri's "The Power of Passive Investing" for confirming evidence. Passive-Index investing places a collar around impulsive trading.

3. Passive-Index investing is cost effective.

Most brokers provide a list of commission-free ETFs. For example, TDAmeritrade has a list of 101 such ETFs. Any reduction in expenses immediately elevates the Internal Rate of Return.

4. Passive-Index investing is simple and not difficult to implement.

Selecting four to seven index ETFs provides the core of a portfolio. It is possible to build a well-diversified portfolio with as few as three or four index commission-free ETFs. That is about as simple as it gets. No stock analysis is required. Fewer ETFs are required to build a diversified portfolio than is possible with individual stocks.

5. It is easy to construct a well-diversified global portfolio.

Index ETFs provide the small investor with the opportunity to expand into global markets either by selecting broad market ETFs or ETFs that focus on specific countries.

6. Index ETFs provide the small investor with access to emerging markets, international REITs, international bonds, and commodities that would be difficult to accomplish with individual stock selection.

7. Investors can tailor portfolios to make use of academic research.

It is easy and convenient to use, for example, Fama-French research to tilt portfolios toward particular asset classes.

What are the disadvantages of Passive-Index investing?

1. Passive-Index investing lacks excitement as the portfolio will follow the movement of the market. One is left out of hot stock tips and water-cooler stock discussions.

2. Socially responsible investor do not have the same control over what is included in the portfolio. Buying baskets of stocks automatically mean there will be unacceptable companies found somewhere in the ETFs used to build a portfolio. While the percentage is very small, there will be "sin stocks" present in the portfolio.

3. "Beating the Market" is highly unlikely unless one is sufficiently lucky to come up with a Strategic Asset Allocation plan that happens to work better than the broad market average. This is a chance event. Passive-Index investors are content with market returns. The good news is that these returns outperform the majority of actively managed mutual funds over the long run.

While I strongly favor a passive-index approach to investing, I'm grateful for all the active investors who are out there buying and selling individual stocks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.