Actively managed vs. indexed mutual funds – Why I use a passive approach to investing

Actively managed vs. indexed mutual funds – Why I use a passive approach to investing

I’ve just finished listening to a webinar session led by Rick Ferri, who offers low cost passive investment management at his firm, Portfolio Solutions (www.PortfolioSolutions.com).  Rick has been at nearly every Garrett Planning Network retreat that I’ve attended, and I’m always impressed with his passion and knowledge about investments.

This particular webinar is titled “The Death of ‘Buy & Hold’ Has Been Greatly Exaggerated”.  Rick summarized the findings in his most recent book, “The Power of Passive Investing”.  Rick talked about 2 types of active management – active management through using actively managed mutual funds, and active management through tactical allocation (a.k.a., market timing).

Actively managed mutual funds vs. indexed funds

Rather than the usual focus on fees, he shows that across most asset classes, two thirds of actively managed mutual funds underperform the index.   (Which means, most would underperform a low-cost index fund, just by a bit less.)  Similar findings are found in past studies, and can be seen to some extent in the S&P Indices Versus Active Funds Scorecard, available at the Standard and Poor’s website.

Market timing

Can you pick the best day to get into and out of the market, or a sector, or a geographic area?  Books on behavioral economics tell us that we want to believe that it’s possible to foresee changes in the market, and that we can be successful doing so.  However, evidence typically refutes our impressions, and Rick presents some interesting evidence about tactical allocation.  For example, he showed a “buy and hold” vs. tactical allocation strategy for the years 2000-2010.  The “buy and hold” – with no rebalancing, just “set & forget” – yielded 6.2% annually over that time period; the tactical allocation yielded 5.4%.  Rebalancing the “buy and hold” portfolio increased the difference in yields.

Am I convinced?

Rick makes a compelling argument for the passive investment approach (or, as he’d call it, “Passive/Passive” to indicate that neither investment selection nor timing are actively managed).  The active vs. passive management debate still rages, with proponents able to point to various studies supporting their views.  Based on Rick’s work, the odds don’t appear to be in favor of a successful active approach, although he’s the first to admit that the market can be beaten – just not always.  I continue to be open to being convinced that there is an active investment approach that works.  For now, I’m sticking with the passive approach.