A Few Notes on The Power of Passive Investing

January 28, 2011 • Posted in Big Ideas, Investing Expertise, Strategic Allocation

In his 2011 book The Power of Passive Investing: More Wealth with Less Work, author Richard Ferri presents “the detailed studies and undeniable evidence favoring a passive investing approach. …This information clearly shows that trying to beat the market has never been a reliable investment strategy in the past, and there’s no reason to believe it will beat a passive approach in the future. …Attempting to earn above market returns by picking actively managed mutual funds is an inefficient use of time and money. Knowing this fact, and acknowledging it allows you the freedom to go in a different direction–to change religion in a sense. …This book makes the case for passive investing. You’ll have to read other books for details on asset allocation recommendations and fund selection methods.” The book includes 140 citations of formal studies and expert commentaries. Some notable points from the book are:

From Chapter 1, “Framing the Debate” (Page 14): “The ideal choice for investors is a strategic asset allocation implemented with low-cost passively managed index funds and ETFs that follow market benchmarks. This approach provides the highest probability for achieving financial success.”

From Chapter 2, “Early Performance Studies” (Page 32): “…early performance studies…point to a few basic conclusions that appear to always be true: (1) in the aggregate and before expenses, active management appears to add little value over market benchmarks, (2) after expenses the probability for adding value drops precipitously, and (3) the excess returns earned from the winning funds are not high enough to compensate investors for the high shortfall from the losing funds.”

From Chapter 3, “The Birth of Index Funds” (Page 40): “The Vanguard 500 Index Fund has performed exactly how the academics anticipated. Low fees in the fund and low turnover propelled the fund into the top echelon of fund performance over the years…”

From Chapter 4, “Advances in Fund Analysis” (Page 59): “The probability of finding consistent alpha in active management diminishes as research advances and more multi-factor risk models are formed. …Investors can now easily create a passive portfolio that provides the same risks and return expectations as active management for a fraction of the cost.”

From Chapter 5, “Passive Choices Expand” (Pages 76-77): “…active management cannot compete against passive management in any asset class, style or sector in the long run.”

From Chapter 6, “Portfolios of Mutual Funds” (Page 92): “Active fund investors have strong headwinds against them. The probability of selecting a winning fund is low; the average payout from those winning funds does not compensate them enough for the shortfall of being wrong; the addition of several active funds in a portfolio reduces the probability of success; and the longer that portfolio is held, the odds drop even more.”

[On 1/28/11, author Richard Ferri commented via email: “…the big point in chapter 6 is that active manager risk cannot be diversified away by adding more managers. In fact, the more active funds in a portfolio, the higher the risk, and the greater the probability the portfolio of active mutual funds will underperform a comparable portfolio of index funds.”

From Chapter 7, “The Futility of Seeking Alpha” (Pages 115-116): “Most people who seek alpha don’t find it, especially when they use the three common methods of past performance, fund ratings, and low fees. Winning with active funds appears to require a skill set that goes well beyond analyzing quantitative factors and deep into understanding qualitative factors…most investors and advisors don’t have this information or the skill to analyze it. …A better solution is not to waste time trying to find talent when so little exists.”

From Chapter 8, “Active and Passive Asset Allocation” (Pages 131-132): “…trend following behavior likely results in a loss of more than 1 percent per year in investors’ portfolios. Passive investors outperform those who attempt tactical asset allocation. Through regular rebalancing, passive investors benefit from the mistakes of people who follow the crowd into past performing sectors.”

From Chapter 9, “Changing Investor Behavior” (Page 152): “Maintaining a portfolio of index funds based on a sensible investment policy has the highest probability of meeting your financial goals. Why, then, don’t more people follow this approach? There are a variety of reasons, including a lack of awareness, a lack of understanding, a lack of belief, and simple procrastination.”

From Chapter 10, “The Passive Management Process” (Pages 157-158, 173): “The five step process for passive portfolio management [(1) Determine objective, (2) Analyze asset classes, (3) Create strategic asset allocation, (4) Choose representative securities, and (5) Implement and occasionally rebalance] provides a sound, effective, and efficient path to investment design, implementation, and maintenance. Following these steps religiously helps ensure that a portfolio…provides the greatest probability for its success.”

Reasons to be cautious about the finality of the above points include:

  • Empiricism (the scientific method) is unequipped to support belief without doubt, which instead requires some other epistemological setting. The religion metaphors cited above in the introductory paragraph and the excerpt from Chapter 10 seem apt.
  • The complexities and uncertainties inherent in financial markets theory and data are, as in other arenas of the social sciences, especially unfriendly to definitive belief.
  • The belief in the superiority of passive investing seems dissonant with the common sense belief that ability plus hard work pay off. Posed differently, if ability plus hard work convey reasonable rewards in other (often complex and uncertain) fields of human endeavor, why not in investing?
  • A seemingly unabated stream of contrary research, much reasonably rigorous, argues for consideration of some level of real merit in seeking alpha. See “Persistence of Diversity in Investor/Trader Beliefs” and “The Adaptive Markets Hypothesis” for different perspectives.

The market, macroeconomic, corporate and individual implications of a model in which all participants accept the proposition that passive investing is superior, and therefore abandon all pursuit of alpha, might be illuminating with respect to these cautions.

For another synthesis of research (with less definitive conclusions), see “Investing Demons”. See also the “Investing Expertise” and “Mutual/Hedge Funds” collections of research summaries.

In summary, careful consideration of the body of evidence presented in The Power of Passive Investing will help alpha-seeking investors and advisors calibrate their expectations.


Why not subscribe to our premium content?
It costs less than a single trading commission. Learn more here.
Login
Current Momentum Winners

ETF Momentum Signal
for November 2014 (Final)

Momentum ETF Winner

Second Place ETF

Third Place ETF

Gross Momentum Portfolio Gains
(Since August 2006)
Top 1 ETF Top 2 ETFs
206% 221%
Top 3 ETFs SPY
211% 83%
Strategy Overview
Recent Research
Popular Posts
Popular Subscriber-Only Posts