Statistics About Indexing's Advantage May Be Lying To You: Financial Advisors' Daily Digest

by: SA For FAs


A new study by Dalbar finds that passive funds achieve higher returns, but active fund investors are better behaved and may actually come out ahead over the long term.

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By now everybody knows that passive trumps active, right? That’s certainly become the new conventional wisdom. And that’s not just the word on the Street – we’re talking actual dollars bleeding out of, make that hemorrhaging out of active mutual funds. The bleeding has been going on for well over a decade, but has accelerated over the past two years. Active funds have known only outflows for the 22 consecutive months ending on Dec. 31.

What’s more, after this weekend’s eagerly anticipated shareholder letter from Warren Buffett, who not for the first time advocates index funds, whence will active management find succor (i.e., encouragement, not the suckers who conventional wisdom holds are active’s last remaining shareholders).

That help may have come in the form of a new study from Dalbar, the Boston-based consulting group famous for its now decades-running Quantitative Analysis of Investor Behavior annual studies, which have consistently shown that investment performance trounces investor performance. That is to say that if the S&P 500 has returned an average of 10.35% a year over the past 30 years, actual equity fund investors have reaped just 3.66% a year of that performance as a result of their naughty investment behavior – such as chasing returns or selling in panic.

Dalbar decided to use this same behavioral insight, i.e. that fund performance and investor performance can vary a great deal, in order to measure for the first time claims that passive investing beats active investing. The firm’s conclusion is that yes, passive funds achieve higher returns, but that active fund investors are better behaved, as it were, and may actually come out ahead over the long term.

“If investment returns were the only criteria, there would be little argument to ever use an active investment,” says Dalbar. But other behavior-influencing factors tilt the results against passive investors. For example, if you own XYZ mutual fund, its investment results are reported daily. But you’d have to take the trouble to look up those results. If you own an index fund tracking the S&P 500, on the other hand, its benchmark is reported second-by-second through the financial media.

In other words, Dalbar’s study suggests a correlation between investor buy and sell decisions and external events influencing volatility in securities prices. Specifically, the firm finds that passive funds beat active funds in rising markets, whereas active funds beat passive when markets decline. While markets rise more often than they decline, one can possibly infer that panic-selling has an especially damaging effect on long-term returns since active fund investors’ edge has increased with time over the 15-year period Dalbar studied.

To be clear, both active and passive fund investors have done poorly compared to market returns in the 15 years ending Dec. 31, 2016, which Dalbar examined. But active investors’ apparent greater willingness to stay put enabled them to capture annualized returns of 4.04% over the past 15 years compared to 2.85% for passive investors (compared to 4.98% for the S&P 500). That’s a 119-basis-point advantage for active over passive. In 2016, though, passive beat active by 265 basis points, an advantage Dalbar thinks is distorted by the post-Trump election victory rally. That advantage persisted, but shrank, over the past three years to 174 basis points. But active beat passive over five years and tied over 10 years.

Dalbar’s point in all of this seems to be that investment characteristics alone (such as low expense ratios or high historical returns) are an insufficient basis on which to make investing decisions. Rather, each investor’s behavioral tendencies should be factored into the equation. That implies that investment products – and decisions as to whether to hire an investment professional or obtain some other form of assistance – should be tailored to each investor individually.


It is with this perspective in mind that I want to notify readers of a new premium on Seeking Alpha’s Marketplace called “Wealth Watchers,” designed for people who want something in between engaging a financial advisor and doing things completely on their own. The new forum will serve as a mutually supportive peer group with knowledge and perspective on the how-tos of earning, saving and investing with the aim of achieving financial independence.

Please share your thoughts in our comments section. Meanwhile, here are a few advisor-related links for today:

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.