Active vs. Index Investing

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In the midst of major change

A centuries-old premise is finally falling from grace: that an elite group of money managers can find good deals in the stock market, and that investors can identify these gifted money managers, follow their advice, and beat the market.

An entire industry is built up around this false premise, and this industry is powerful and entrenched. Nevertheless, the cracks are visible. Every day individuals and institutions are rejecting this industry and turning to index investing as the most effective way to multiply their capital.

In this essay you will learn about the differences between active and index investing. We will lay out the case for index investing, which will include academic theory, historical evidence, recent changes in the actions of institutional investors, and the impact index investing will have on your savings and retirement. On the left you can see links to other essays that explore specific topics in more details, offering more proof points.

Why the failure of active investing matters to you

The reason all of this matters is that IT’S YOUR MONEY we’re talking about here. Money is some of the very hardest stuff to get, and most people work very, very hard to acquire it. Those lucky enough to have it either respect their good fortune or lose it.

No matter how much you enjoy what you do, eventually you will be doing less of it. In the meantime, while you’re laboring, you need to be the best capitalist you possibly can. Fortunately for you, the world equity markets have evolved to the point where you can apply the soundest investment principles with very little work. This is true despite being counter-intuitive, as you’ll learn.

The appeal of active investing

The core principle of Active Investing is that there are inefficiencies in the prices of securities that can be identified AND exploited. Note that both are required: there have to be good deals to be found, and the profit to be gained has to be more than the cost of researching the securities, buying them, and then selling them. In addition, the profit from these good deals has to more than make up for the losses on any mistakes.

Active Investing has a great deal of commonsense appeal. After all, who doesn’t pride themselves on getting a good deal, whether on a plane ticket or a digital camera. Unfortunately for this noble notion, the equities markets are almost perfectly efficient. At this very minute there are 200,000 people poised at Bloomberg terminals around the world, tirelessly scanning for news that will move one or more stock prices. The corners of the market that are less efficient, such as small companies in foreign countries, have transaction costs that prevent any inefficiencies from being profitably exploited. You don’t have to take this highly charged accusation on faith – as we’ll see the evidence is diverse and compelling.

Index Investing for Efficient Markets

Index Investing is harder to understand, but much simpler to execute. Index Investing stipulates that efficient markets cannot be exploited once fees and taxes are taken into account, but that capitalism itself is the underlying driver of wealth creation. The successful investor seeks to match an acceptable level of risk to the maximum reward by investing in a diverse basket of stocks and bonds, and by minimizing transactions and fees. This is typically done through the purchase of ten to twenty special low-fee mutual funds that mirror the performance of particular asset classes. These mutual funds are often called Index Funds, because the original funds of this type attempted to mirror the performance of indices such as the S&P 500.

Insitutional investors choose indexing

About 50% of institutionally invested money is invested in index funds, yet 90% of individual assets remain in active strategies. Thanks to author Larry Swedroe for capturing some of these moves:

1995 – Intel fires all of its active managers (Wall Street Journal, 8/24/95)
1999 – Phillip Morris eliminates active management of $8 billion in pension assets (Pension & Investments, 8/9/99)
2002 – ExxonMobil moves the remainder of its $14 billion in pension assets into indexing (Pensions & Investments, 9/16/02)

These giant companies have massive pension obligations, including many fixed obligations. They MUST get maximum return for the risk they are willing to take. They have access to the very brightest investment advisors in the entire world. Yet they chose to completely eliminate active investment.

Individuals are adopting institutional approaches

Over the next few decades, as the public comes to better understand the loser’s game they are playing, a huge amount of money will flow into index funds. The goal of RAA is to help individuals transition to index management, and to take advantage of some of the newer quasi-indexing vehicles that are generally available only to large institutions.

Here’s the chain of thinking that has resulted in the surge in index investing among institutions. Rather than marshalling the evidence for each of these statements, we’ve chosen to link many of them to essays that address these in detail. Many books also do the same.

Why indexing wins

The equity and bond markets are highly efficient. Transaction costs eliminate any earnable profit from remaining inefficiencies.
Past performance of fund managers is a very poor predictor of future performance.
Fees are the enemy of any fund. The only fund characteristic that correlates highly with returns is fees. The lower the fees, the higher the returns of stock and bond funds.
Buying and selling, required of active managers, triggers taxes. In taxable accounts, this is an almost impossible hurdle for active management.
Index funds exist with very low management fees, low turnover, and low taxes.

A few corollaries for individual investors

If skilled professionals are unable to succeed at beating the market, you will not succeed either. If you are an active investor, you are likely to be overconfident of your investing skills.
You cannot replicate the effectiveness of existing index funds by buying individual stocks.
You will achieve superior performance with a financial advisor – meaning that RAA is worth the money you’ll pay us.

You are a Capitalist

Now, back to the matter at hand: You are a Capitalist, and you expect to be paid as such. Your capital is the lifeblood of the global economy. If you aren’t getting the return you want, you can move your capital somewhere else. Anyone getting between you and the basic returns of an index fund has some explaining to do.

If you’re a typical active investor, buying mutual funds, your returns are far less than those of the stock market itself. If you’re buying stocks directly, you can eliminate the mutual fund and instead substitute your transaction costs and your probable underperformance of the appropriate benchmark. Individual active investors typically do poorly.

Question: What happened?

The stock market has returned approximately 11.6% annually since 1926
Inflation averages 3.2% annually, leaving you with 8.4% in real returns
Your mutual fund manager, who in this exercise is getting credit for hitting the stock market’s underlying benchmark prior to expenses, is taking 1.5%. Most mutual funds underperform the market by around 2%, so we are being generous.
Taxes take another 1.7%. This is primarily short term capital gains due to the 81% turnover that is typical in an actively managed fund.
You capture 5.3% real gains. Note that this is less than 2/3 of the stock market’s true increase of 8.4% after inflation.

Answer: You’re not the capitalist you should be.

A lot of your profits went to others, including the government. Your money is going to take a lot longer to grow if you can’t escape these drags on your profits.

Doubling your money in less time

There is a handy rule of thumb that calculates how long it takes for your money to double. 72 divided by the interest rate gives you the length in years that your money will take to double. For example, an interest rate of 8% results in your money doubling in 9 years, since 72 ÷ 8 = 9. An interest rate of 4% doubles you in 18 years, or twice as long.

For those who are more heavily invested in bonds, the picture is much worse. Bonds carry less risk, so they have less return with which to absorb the profits of your silent partners.

Yes, you are reading this chart correctly. By the time you subtract inflation, active fund management fees, and taxes due to trading, you’re barely above water in real terms.

Note that if you are investing in tax-free bonds, you can lower the return from 5.7% to 5.3%, then add back the 1.8% taxes, delivering you a real return of 2.1%. Still pretty dismal considering that others are doing far better by eliminating active fund managers.

Taxes - what you don’t notice can hurt you

Because so few people correlate their tax payments on April 15 with their returns throughout the year, taxes tend to be the biggest surprise for most investors learning about index investing for the first time. Individuals tend to think that because they haven’t sold their investment, they won’t pay taxes. This just isn’t the case. If your fund manager is busy flipping stocks or bonds, and most are, their activity will trigger taxes that you will have to pay. You’ll receive a 1099, which is basically a bill payable to the federal and state agencies. Paying this bill reduces your investable income, and therefore reduces your ability to achieve decades of compounding prior to paying these taxes.

Remember, there’s nothing inherently fair or unfair about the government’s taxation rules. It just so happens that index investments do not trigger taxes because they do not incur turnover. You will still pay the same taxes, but you will do so at a time of your choosing, after you’ve had the benefit of compounding for many decades. US taxation rules impose a heavy burden on any stock-picking strategy. Learn more about taxes and active investing.

Keeping more of your money

In this main article, and in the articles linked to it, we’ve laid out a clear case against active management. Those guilty of siphoning your profits include active mutual fund managers, and the government. To be a better capitalist you need to deny these culprits access to your money.

Here’s what an index investor can expect to keep from his investments:

Inflation is the same as before, and other losses are lower.

What Ross Asset Advisors does

One final question remains: what does RAA do?

Ross Asset Advisors can help you create a passive, index portfolio that meets your financial goals. Depending on your level of wealth, we will include a combination of funds plus individual bonds, including municipal, agency, and sometimes corporate. Once built, this portfolio is maintained and tweaked over time as you put money in, take it out, and as your assets increase in value, often at different rates.

You probabaly have more opportunities than you know to legally avoid taxes. Choosing among the many types of retirement accounts so as to minimize taxes is often not something that accountants fully understand. There is no more direct way to positively impact your investments than to pay less to the government.