The Active vs. Passive Debate: A Brief Overview
I recently enjoyed an episode of Freakonomics Radio called, "The Stupidest Thing You Can Do With Your Money." It's a fantastic discussion of what is being referred to as a revolution on Wall Street: the widespread embrace of low-cost indexing.
The premise for low-cost index funds and ETFs is simple: It's hard to beat the market.
How hard is it, you ask? Even highly-paid, well-educated, super-experienced mutual fund managers struggle to outperform the simple, elegant, computerized and automatic S&P 500 index funds like VFIAX (Vanguard), SWPPX (Schwab), and FUSEX (Fidelity), just to name a few.
Let me provide some details: According to the SPIVA® U.S. Scorecard published by S&P Dow Jones Indicies, during 2016, two-thirds of all large-cap mutual funds underperformed the S&P 500. Look at the past five years and 88% underperformed the market. And over the past fifteen years? 92% performed worse than the S&P 500.
Furthermore, the June 2017 Persistence Scorecard explains how rare it is for actively managed mutual funds to yield consistently high returns:
Out of 568 domestic equity funds that were in the top quartile as of March 2015, only 1.94% managed to stay in the top quartile at the end of March 2017. Furthermore, 0.92% of the large-cap funds, 2.38% of the mid-cap funds, and 2.26% of the small-cap funds remained in the top quartile.
The bottom line: It's hard to find a good mutual fund. It's even more difficult to find a consistently good mutual fund.
So what do you do if you can't beat 'em? Join 'em! According to John (Jack) Bogle, founder of Vanguard and creator of the first index fund, investors are catching on. As Bogle said in the Freakonomics Radio podcast mentioned above, ...
The number comes out to around a trillion and a half flowing into index funds and a half a trillion flowing out of active funds, which is a $2 trillion shift in investor preferences. It is a revolution.- John Bogle on Freakonomics Radio
But here's the thing... All of these statistics and a great deal of the active vs. passive investing debate focuses on the failure of underperforming mutual funds. These clunky, giant pots of money exceed hundreds of millions or even hundreds of billions of dollars. Mutual funds are plagued by high fees, government regulations, and the numerous hassles of dealing with such large amounts of money.
Personal investors are in an entirely separate category with a different set of limitations, challenges, and opportunities. I believe it is far easier for individuals to build strong portfolios that beat the market than it is for mutual fund managers to do so. More on that in my next post. Stay tuned.
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