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BAM Intelligence

Have We Reached the Tipping Point in the Active Versus Passive Debate?

Novelist Victor Hugo observed: “There is one thing stronger than all the armies of the world, and that is an idea whose time has come.” And the time for passive investing is now.

Investors continue to learn the lesson that poor returns don’t come cheaply; you have to pay dearly for them. The markets keep teaching us that while active management does provide for the possibility of market-beating performance, the much greater likelihood is underperformance. The data on mutual fund flows indicates investors are getting tired of the poor and inconsistent performance of actively managed funds. All one must do is review the results of the annual SPIVA scorecard. Reading these reports will surely provide you with a sense of déjà vu.

As one indicator of how strong the trend toward passive investing has become, the first half of 2016 set another record for The Vanguard Group. The firm, which has grown into the world’s largest mutual fund manager by offering low-cost investments, attracted $148 billion in new client money during the first six months of this year – surpassing its previous first-half record of $140 billion set last year. In June alone, about $30 billion flooded into the firm’s mutual funds and exchange-traded products.

Vanguard continues to benefit from a growing preference among investors for low-cost, passively managed vehicles that track indexes. And the heightened competition from providers such as Schwab, Fidelity and BlackRock suggests that even lower expense ratios are likely. Even Goldman Sachs has joined the game with its “smart beta” offering, the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC), which has an expense ratio of just 9 basis points.

The trend toward low-cost, passive investing received further impetus with the new Department of Labor fiduciary rule that requires investment advisors to act in the best interest of clients when they’re providing retirement advice. This ruling may have been the tipping point that accelerates movement in the direction of passive investing. Which brings to mind this quotation from Brutus in Shakespeare’s Julius Caesar:

“There is a tide in the affairs of men.
Which, taken at the flood, leads on to fortune;
Omitted, all the voyage of their life
Is bound in shallows and in miseries.
On such a full sea are we now afloat,
And we must take the current when it serves,
Or lose our ventures.”

While the momentum building behind passive investing has been relentless, it has also proven relatively slow – especially among retail investors – gaining market share at a rate of less than 1 percent a year. But the trend now appears to be accelerating. And to help understand why, I offer the following words of wisdom from three investment legends.

Nobel Prize winner William Sharpe demonstrated that, collectively, active management is a negative-sum game, also known as a loser’s game. It is simply a matter of costs. Not all active investors earn below-benchmark returns. Active management does hold out the hope – but not likelihood – of outperformance. It is probably safe to say that there is no other effort on which such an expense is incurred, every year, with such poor results. The reason is that no one has yet found a way to identify the few future winners. Past performance is a poor predictor of future results (hence the SEC warning).

While Wall Street and the financial media continue to tout the benefits of active management, consider the following words of wisdom from two more investment legends. On all of the supposed advantages held by investment professionals, Peter Lynch opined: “[Investors] think of the so-called professionals as having all the advantages. That is total crap. They’d be better off in an index fund.” (“Is There Life After Babe Ruth,” Barron’s, April 2, 1990.)

The following three quotations are from Warren Buffett. In 1996, he wrote: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals. Seriously, costs matter.” (Berkshire Hathaway Annual Report, 1996.)

In an interview with Fortune magazine, Buffett offered this advice: “Buying an index fund over a long period of time makes the most sense.” (Andy Serwer and Julia Boorstin, Fortune, November 11, 2002.)

Buffett also offered this observation in his 2004 annual letter to shareholders of Berkshire Hathaway: “Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.”

If you haven’t joined the passive “revolution,” it’s time you did.

This commentary originally appeared July 13 on MutualFunds.com

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© 2016, The BAM ALLIANCE

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Larry Swedroe

Chief Research Officer

Larry Swedroe is Chief Research Officer for the BAM ALLIANCE.

Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College.

To help inform investors about the evidence-based investing approach, he was among the first authors to publish a book that explained evidence-based investing in layman’s terms — The Only Guide to a Winning Investment Strategy You’ll Ever Need. He has authored 15 more books:

What Wall Street Doesn’t Want You to Know (2001)
Rational Investing in Irrational Times (2002)
The Successful Investor Today (2003)
Wise Investing Made Simple (2007)
Wise Investing Made Simpler (2010)
The Quest for Alpha (2011)
Think, Act and Invest Like Warren Buffett (2012)
The Incredible Shrinking Alpha (2015)
Your Complete Guide to Factor-Based Investing (2016)
Reducing the Risk of Black Swans (2018)
Your Complete Guide to a Successful & Secure Retirement (2019)

He also co-authored four books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006), The Only Guide to Alternative Investments You’ll Ever Need (2008), The Only Guide You’ll Ever Need for the Right Financial Plan (2010) and Investment Mistakes Even Smart Investors Make and How to Avoid Them (2012). Larry also writes blogs for MutualFunds.com and Index Investor Corner on ETF.com.

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