A couple of weeks ago, an icon in our business, John Bogle, passed away at the ripe old age of 89. When I was getting started in this business in the 1980s, we worked exclusively with actively managed funds. Back in the early days of the mutual fund business, actively managed funds were practically all that were available. They supported us and helped educate us to the advantages of pooled investments and diversification.
John Bogle was the founder of Vanguard and he advocated passionately for his revolutionary low-cost passive index approach to investing through the Vanguard mutual funds. To many of us back then, John was the enemy and we all felt like it was his goal in life to put us out of business. There is no doubt that John was a pioneer and a visionary, and events have proven him right. Or, at least, half right. But, more on that later.
With excerpts from Mark Perry's economics blog on January 17 where he paid tribute to "the capitalist for the common man", let's look at Mr. Bogle's passive, index approach to investing. Mr. Perry begins with a couple charts:
Then, Mark follows with commentary:
1. Active vs. Passive Investing I: The table is from a CD post last October "More evidence that it's really hard to 'beat the market' over time, 95% of finance professionals can't do it, "based on the SPIVA U.S. Mid-Year 2018 report from S&P Dow Jones Indices, the de facto scorekeeper of the active versus passive investing debate.” The main empirical result of the report displayed above was that over the most recent 15-year investment horizon from June 30, 2003 to June 30, 2018, 92.43% of large-cap fund managers, 95.13% of mid-cap fund managers, and 97.70% of small-cap fund managers failed to outperform their respective benchmark indexes: S&P 500, S&P MidCap 400 and S&P SmallCap 1500.
Stated differently, over the last 15 years only one in 13 large-cap managers, only one in 21 mid-cap managers, and one in 43 small-cap managers were able to outperform their benchmark index. So, it is possible for some active fund managers to “beat the market” over various time horizons, but there’s no guarantee that they will continue to do so in the future. And the percentage of active managers who do beat the market is usually pretty small – fewer than 8% in most of the cases above over the last 15 years; and they may not sustain that performance in the future. For most investors, the ability to invest in low-cost, passive, un-managed index funds and outperform 92% of high-fee professionally managed active funds seems like a no-brainer, especially considering that investing in index funds requires no research or time trying to find the active managers who beat the market in the past and take the risk that they may or may not do so in the future. Investing in the market with an index fund guarantees that you’ll always earn the market return with zero risk of ever under-performing the market. Investing in an actively managed fund (or hedge fund) exposes you to the ongoing and significant risk of under-performing the market.
2. Active vs. Passive Investing II: The bottom chart above shows a similar comparison over a similar 15-year period from December 2003 to December 2018 between the S&P 500 and the average hedge fund, using annual return data for the S&P 500 Index from the NYU Stern School and annual return data for the average hedge fund from the Barclay Hedge Fund Index. The return on the unmanaged S&P 500 Index was higher than the average hedge fund return in 12 of the 15 last years, and higher in each of the last ten years. A $1,000 investment in December 2003 in the S&P 500 Index would have slightly more than tripled over the last 15 years to $3,043, generating an average annual compounded return of 7.70%. In contrast, a $1,000 investment in the average hedge fund would have only slightly more than doubled over that period to $2,094, from an average annual return of only 5.05%. More evidence that it’s very difficult, even for experienced, highly educated professional hedge fund managers, to “beat the market” over time.
Mr. Perry concludes his post with a comment about Warren Buffet’s take on all this - “Consider these words from perhaps the wisest investor of all, Warren E. Buffett, from the 1996 Annual Report of Berkshire Hathaway Corporation: 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.”
The results seem clear that passive investing beats active managers. While it is true that some active managers do beat the market for short periods, it is not always the same ones, and they are unable to do it consistently over time. Also, there are surveys that show that portfolios constructed of passive index funds outperform portfolios made up of actively managed funds.
So, why did I say that Mr. Bogle was half right? What I mean by that is John’s philosophy was to buy index funds, his Vanguard index funds, and hold them. Buy and hold. What does that really mean? As we show in a video on our website, We Are Not Your Old Stock Broker, there have been 16 bear markets since 1929. The average bear market decline has been 38.24%. What buy & hold means is that you are signing up for a loss/decline of 38% every 5.3 years! Is that what you signed up for? John, RIP, did not spend much time discussing that “side of the coin.”
Petra Financial Solutions has adopted a strategy that actively manages passive index funds. As we say in the video, we are playing the piano with both hands. Our goal is to avoid as much of true bear markets as possible. Corrections like late 2015 - early 2016, and the last quarter are a challenge. Is this a correction, or is it the beginning of #17? Our process is not perfect, but we strive to do better every day.
Are You Ready For Bear Market #17?
Until next time, Cheers!
Jim