The Power Of Passive Investing: Book Notes

This post has my personal notes about the big ideas in The Power Of Passive Investing by Richard A. Ferri.

The Active Versus Passive Debate

In the beginning, the role of active fund managers was to offer diversification at a reasonable cost. However when the first index fund was launched, their focus changed, and they insisted their managers could beat the markets. The reason why they changed their focus was to protect their business of making money by managing other people’s money. However, the data consistently suggests that they cannot beat the market. Over the decades there has been an explosion of indexing products. Passive investing through ETFs and index funds is possible in almost all major asset classes and across styles and sectors, providing investors with a multitude of choices.

The passive versus active debate also includes portfolio management. Portfolio management can be a passive strategic asset allocation strategy or an active tactical asset allocation strategy. You can use passive index funds or active funds to carry out either strategy. Using a passive strategic asset allocation strategy with passive managed low-cost index funds and ETFs is lowest-cost strategy with the highest chance of achieving financial success.

Performance analysis of passively managed funds and active funds give these conclusions:

  • Before expenses, active management appears to add little value over market benchmarks
  • After expenses, the probability of adding value drops precipitously
  • The excess returns earned from the few winning funds are not high enough to compensate investors for the high shortfall from losing funds.

The first low cost index fund(Vanguard 500 Index fund) has performed brilliantly over the decades because of its low cost and low turnover and has made a lot of investors manage their investments in a passive way.

The risk factors which explain investing returns are as follows:

  • Market risk(beta): The difference in return between investing in stocks versus investing in T-Bills.
  • Firm size factor: Small company stocks have higher returns than large company stocks.
  • Value factor: Companies with low Price/Book value ratios have higher returns than companies with low Price/Book value ratios.
  • Momentum: Stocks that are relative winners over the past 3-12 months continue to be relative winners over the next 3-12 months and stocks that are relative losers over the past 3-12 months continue to be relative losers over the next 3-12 months

Once you account for these risk factors, the probability of finding skill in active managers is minimal. There are many low-cost index funds and ETFs that exploit these factors for a fraction of the cost of active management.

In every asset class, the odds of beating index funds are low, and the payout for being right is well below what a what a fair payout should be. Hence active management cannot compete against passive management in any asset class, style or sector in the long run.

The chance that an actively managed portfolio of 5-10 different funds will beat a passively managed portfolio of 5-10 different funds is 1-3% over 25 years.

Probability of active funds beating passive fundsHence over the long run  a portfolio of market tracking index funds and ETFs is superior to active management and is the most efficient way to reach your financial goals.

Chasing Alpha and Changing Behaviour

It is futile to chase alpha or market beating returns. There are many reasons:

  1. The probability of selecting winning active funds is low.
  2. The payout of success is low compared to the risk.
  3. Superior performance does not last for long and often degenerates into inferior performance.
  4. Past performance is unable to predict future returns.
  5. Low cost active funds do not outperform low cost passive funds.
  6. Fund ratings do not predict out-performance.

Winning with active funds needs deep understanding of qualitative factors. Despite deep understanding, there is no guarantee that this will work. Most investors and advisors do not have the skill or information to get this deep understanding. There is no point trying to waste time trying to find talent when so little exists and and the brightest talent is scooped into hedge funds. It is better to be certain of a good return than be hopeful of a great one. Passive investing will certainly give you that good return.

Passive asset allocation(strategic) almost always wins active asset allocation(tactical). A high percentage of new money flows into asset classes, sectors and styles that have had recent high returns. This results in lower returns. If money flows into active funds, you lose more. Passive investors gain from these mistakes and outperform active investors.

Passive investing is a simple solution to a complex problem giving you the highest chance of meeting your financial goals. However, many people do not follow this approach. Why? The reasons are many

1. Lack of awareness and understanding. Teach them: personally, by books, by websites, by anything. Do not go to Wall Street to get advice.

2. Lack of belief in passive investing despite knowing about it. They have to remember the following:

  • Only successful investors and mutual funds are advertised because it makes for good business. Read this confession from a former mutual fund reporter to understand this.
  • Active management spends a lot of money in the investment marketplace. They decide what is said in the media.
  • If an investor makes excess stock returns from lucky stock picks, they often  attribute their success to something other than luck. This is the winner’s curse. This false belief of skill keeps many investors in active strategies and this reduces the probability of their success.
  • People often believe their investment skills are superior because their accounting skills are inferior. They think they are performing better than they are.
  • People choose wrong benchmarks for the asset classes and the investment strategy that they or their  portfolio manager is following.
  • Investors often alter the facts than admit that they have no special investment skills.
  • Wall Street does not give information about past recommendations and real returns.

3.  Procrastination: There can be a lot of time and space between awareness, understanding and commitment. This is probably because we do not have a lot of confidence in the passive approach. Not only that, they fall prey to the endowment approach-belief that what they own is superior to something they don’t own even though that belief is demonstratively not true. They also start the conversion to a passive portfolio but never finish it. They end up in the land of the lost. They also fall prey to their emotions and do not stay the course when the going gets tough. Remember that passive investing will work if you hold the vision. Read this article to learn how a steady hand pays off in unsteady markets.

Remember that investing is serious business. Once you find the best solution, you should follow it through thick and thin. You have to be committed to it like you commit to your career. Sometimes active funds will seem like winning but in the long run, passive investing will outperform. Hence the best solution is to make the jump to passive investing. Just do it!

The Case for Passive Investing

The process for creating and implementing a passive investment plan has five steps:

1. Understanding and defining needs. The five big liabilities are:

  • Education costs for yourself
  • Education costs for family, including children
  • Home ownership
  • Retirement funding
  • Charitable giving
  • Bequest to loved ones

These do not include daily living expenses such as food and clothing or discretionary items such as vacations and recreation.

2. Study market risk and estimate returns: You can find asset class long-term expected risk and returns in this document.

3. Select an asset allocation between various asset classes. The broad asset classes are cash, bonds and stocks

4. Select investments. The investment should have the following traits:

  • The asset class is fundamentally different from other asset classes
  • Each asset class expects to earn a return higher than the inflation rate over time.
  • The asset class must be accessible using a low-cost diversified fund or product.

5. Implementation and maintenance. The last step is to carry out and keep up the plan and check performance.

We might need to change the investment policy sometimes. Four prominent reasons are:

  • The account owner’s financial needs change.
  • Estate planning considerations change.
  • A bull market puts a portfolio close to its financial goal.
  • A bear market exposes more risk than an investor can handle.

These five steps should be incorporated into an IPS(Investment Policy Statement)

The passive case for individual investors involve estimating future obligations and assess assets that we have. Our assets are human capital(ability to earn income), real estate, pensions and social security, inheritances and savings and investments.

The investment pyramid is as follows:

The investment pyramidThe passive approach is not only for individuals but also for institutions, charities and personal trusts and pension funds.

Financial advisors have four options:

Four portfolio strategy optionsThe best strategy is passive strategic asset allocation using passively managed funds because it is likely to be the best long term strategy for both the client and the advisor. It is a win-win strategy.

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