1. Staying passively diversified vs. actively trying to beat the market
2. Keeping costs as low as possible vs. following good past performance funds
3. Removing emotions from investing vs. following the fear and greed cycle
Research shows that following these three simple principles over the long run can add 6% to 8% annually to your portfolio’s performance.
Today we will go over Principle #1 and leave the other two for future newsletters.
The debate of active vs. passive investing has been going on for a long while, and is getting more popular as assets continue to shift away from active management toward passive investing. Cash flows show that from 2007 to 2014, more than $1 trillion net new cash has been invested into passive strategies using index funds or ETFs. In contrast, actively managed US equity mutual funds have seen outflows of more than $650 billion during the same period, according to Investment Company Institute’s 2015 report.
Since 2007 active funds have seen outflows of more than $650 billion, while Index funds / ETFs have seen inflows of more than $1 trillion.
2015 Investment Company Fact Book
The reason for this major index funds/ETFs inflow is simple: research and past funds’ performance continues to demonstrate how difficult it is to beat the market, which is exactly what active funds claim to do. The most recent report published by Morningstar shows that in the last 20 years (1995-2014), there has only been, on average, a 25% chance (for any given year) that a US Large Cap fund beats the S&P 500 index. In fact, active funds underperformed by 1.6% on average each year. Even betting on black (or red) in a roulette game of luck gives you better odds (18 chances out of 38).
Furthermore, this 25% chance of outperformance is on an annual basis and the funds that outperformed in the past year may not continue to do so in future years. Another research conducted by S&P/Dow Jones from March 2009 to March 2014 looked into the ‘Persistence of Outperformance’; into how many active funds were in the top 25% for 5 years in a row. The research showed that only 2 funds out of 2,862 active mutual funds stayed in the top 25% performing funds 5 years in a row, a microscopic 0.07% of all funds. And, as the period of investigation lengthens, we expect the number of funds that are consistently in the top 25% to get very close to zero.
Repeatedly, research and past performance results conclude that it is difficult to beat the market - especially over the long-term. That is why big names in the investing world such as Nobel Prize winning Economist Paul Samuelson, Princeton Finance Professor Burton Malkiel (best known for his bestseller (A Random Walk Down Wall Street), Warren Buffet, and Yale Foundation CIO David Swensen, advise that almost all individual investors and most institutional investors embrace a disciplined passive investing approach.
Lead Advisor, InvestEd.