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A Passive Index Investing Strategy (And Why Active Fund Management Isn’t Worth Paying For)
I am in love with index funds. Basically all of my stock investments are in ETFs (that are tracking various index funds). But, it’s not just me telling you to ditch your human manager and switch to a passive investing strategy. In 2016, investors pulled more than $380 billion from actively managed mutual funds while pouring almost $480 billion in passive investments. Read more praise for passive investing here.
Index funds are a group of securities that have something in common, like an index fund that invests in gold or invests in tech companies. Index funds are a great way to get some diversification in your portfolio and with increased diversification, comes decreased risk. In addition to that, index funds are also typically associated with low management costs and fees. Read more about index funds in my article on stocks and basic investing here and about major U.S. stock indices here.
Pretty great, right? So, something would have to be pretty good for you to want to invest in it over an index fund.
It would have to guarantee higher returns, with a decreased risk, with a decreased cost, right?
What Is Active Management?
Active fund management, a term usually associated with mutual funds where you put your money and a human then manages your portfolio for you, means that you think someone else can do a better job investing your money than you/a computer can. You think that he or she can get better returns on your money than you as an individual can.
And maybe they can.
But, they can’t get better returns than an index fund. A study by the S&P Dow Jones Indices in 2016 showed that “during the one-year period, 84.62% of large-cap managers, 87.89% of mid-cap managers, and 88.77% of small-cap managers underperformed the S&P 500, the S&P MidCap 400®, and the S&P SmallCap 600®, respectively”. And the numbers only grow increasingly unfavorable over the 5 and 10 year investment horizons. (Read the full study summary here.)
Guess what else? They also usually cost a lot more than index funds, too. So, when you factor in the cost of management with the annualized returns, mutual funds look even worse.
Warren Buffett’s Opinion
Warren Buffett and Ted Seides (a hedge fund manager at Protege Partners) bet one million dollars that, starting January 1, 2008, and ending December 31, 2017 (10 years), an index fund (a Vanguard S&P 500 index fund) could outperform a hedge fund manager. So far, the index fund is killing it, though the bet doesn’t officially end until December. Seides actually already published a paper with Bloomberg admitting defeat and offering a few explanations for why he failed so miserably. They are good excuses: he was investing globally, whereas the Vanguard index fund was only in American markets, which have been more bullish than international markets for the past 10 years; that hedge funds perform better in bearish markets; that the S&P 500 has done particularly well the past 10 years, and more (read the full article here).
But for me, they aren’t enough. The hedge fund manager lost, and a lot of his points are actually irrelevant when you consider that most passive investors don’t have all their assets in one Vanguard fund tracking the American market anyways. I have passively invested in domestic and global markets, big, small, and medium-cap companies, and on and on.
So, that is why I decided to go with index funds for my investments (versus something that is being actively managed). I have a robo-managed account because I don’t want a human touching any of my money. I want the lowest risk, a diversified portfolio, low management costs, and great returns. Sure, index funds aren’t perfect, but neither are actively managed funds, and at the end of the day, I feel that index funds are a better fit for my investment strategy.