Our Argument for Passive Investing Just Got Stronger
Summer is traditionally the time to kick back in a hammock with a mindless mystery. However, what’s captured my interest this summer can in no way be described as beach reading. What’s number one on my summer reading list? It’s Professor Kenneth French’s recently published study, “The Cost of Active Investing,” which quantifies the cost of active investing, relative to passive/index investing, in theU.S. equity markets. I don’t want to spoil the ending for you, but French finds that between 1980 and 2006, passive investors earned an average of two-thirds of a percentage point more than active investors. The average investor sacrificed 67 basis points a year by eschewing index funds and trying to beat the market by investing in actively managed funds, hedge funds, and stocks. What’s more, although we all know that past results are no guarantee of future performance, French’s study confirms that the outperformance of passive investing has been relatively stable over a 26-year period.
As you may know, French teaches finance at the Tuck School of Business at Dartmouth College and is a research associate at the National Bureau of Economic Research. He is an expert on the behavior of security prices and investment strategies and is best known for his work with Eugene F. Fama on the Fama and French Three Factor Model. In 1992, they demonstrated that small capitalization and value stocks offered higher historical returns, and that the difference was attributable to the additional risk of holding small company and value stocks. You probably also remember hearing me talk about French in his role as chairman of Dimensional Fund Advisors’ (DFA) Investment Policy Committee and as a member of DFA’s board of directors. His presentations, and the conversations we enjoy afterwards, are always a highlight of DFA’s annual conferences.
What French reports in “The Cost of Active Investing” is even more compelling when you consider his conservative assumptions. For example, in dollar terms, he estimates the total cost of active management at $101.6 billion in 2006. Along with a number of academics and industry experts, I believe that estimate is probably on the low side. In fact, French has noted that he was intentionally conservative in figuring the fees and expenses associated with active management in order to avoid being accused of overestimating the cost. Additionally, in figuring the cost associated with passive management, French assumes the turnover rate in the passive portfolio is 10% a year. While that’s a reasonable estimate, it’s somewhat high in my opinion. Obviously, had French assumed a turnover rate of 5%, the passive portfolio would have compared even more favorably to an actively managed account.
Interestingly, French’s study also shows that passive funds, as a percentage of open-end mutual fund assets, grew at a slow rate, from 1.0% in 1984 to 12.4% in 2002, and accounted for just 12.5% of fund assets through 2007.
Why is it that individual investors have not embraced passive investing? French would argue that people are simply unaware of what he refers to as the “negative sum nature” of the investment process. That is, reflecting the American work ethic, individual investors believe that if they work hard they will earn superior market returns. The catch is, however, that growing numbers of increasingly well-informed investors are all working hard, competing for the biggest slice of the same pie. Staying with the pie analogy, although everyone at the table wants the largest piece, most will need to be satisfied with smaller slices due to the cost of active trading.
Although we may recognize that the odds of scoring big are against us, hope springs eternal that the super-sized slice, or superior investment returns, will be ours. Certainly, Wall Street and personal finance magazines do all they can to promote that optimism. For example, just turn on CNBC or check out the headlines on the covers of magazines in your dentist’s waiting room: “Stocks Poised for a Recovery,” “Top Moves to Make in a Down Market,” and “Bargains Abound in Real Estate.”
It’s no wonder, then, that individual investors, suffering from overconfidence, believe they have the skill to identify the next Microsoft. As we always stress, however, market noise makes it next to impossible to differentiate skill from luck. Even if it was possible to exercise exceptional management skill, as Berk and Green pointed out in their 2002 article, “Mutual Fund Flows and Performance in Rational Markets,” for the Journal of Political Economy, investors tend to chase any evidence of managerial skill and, as assets under management grow in funds with strong returns, the manager’s expertise is diluted.
Read French’s “The Cost of Active Investing,” and the bottom line is clear. Over the 26 years studied, passive investors earned an average of two-thirds of a percentage point more than active investors. Low transaction costs and low management fees are central to achieving superior investment returns.