Passive investing? Smart investing is a better description
Posted by Robin Powell on December 5, 2017
I’ve never liked the term passive investing. For a start, there’s no such thing; all investing involves making active decisions to some extent.
Nor is it always a helpful distinction. Take Dimensional Fund Advisors, for example, whose funds actively seek exposure to specific sections of the market but do so in a broadly passive way.
But my biggest problem with the term passive investing is that it’s dreadful marketing. Nobody, after all, likes to be though of as passive.
The author and former financial planner Jason Butler comes up with a much more appropriate term in Part 2 of Investing: The Evidence, our new documentary, produced in conjunction with RockWealth. It’s smart investing.
This is what he says:
“The term passive investing is not a very good term for people to understand, because it sounds as if you’re standing in the corner, or you’re not participating, or you’re somehow missing out. That evokes emotions — negative emotions. Rather than passive investing, I call it smart investing, no-regrets investing, where I’ve minimised the moving parts and the decisions I have to make, and I’ve minimised the cost, and I’ve maximised the chance of me getting the returns from capitalism which are there for the taking.”
I couldn’t have put it better myself.
If you missed Part 1, you can watch it here:
The remaining four parts, and then the full-length film, will be released at intervals between now and Christmas.
ROBIN POWELL is the founder and editor of The Evidence-Based Investor. A freelance journalist, he runs Regis Media, a specialist content marketing consultancy for financial advice firms around the world. You can follow him on Twitter and on LinkedIn.
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One of the biggest developments in the investing world in recent years has been the growth in popularity of passive investing.
Instead of paying to have their money invested in actively managed funds, investors are increasingly opting to put into index funds, which are very much cheaper, and aim to capture the returns of an entire market by tracking an index.
Personal finance writer Jason Butler says: “The term passive investing is not a very good term for people to understand, because it sounds as if you’re standing in the corner, or you’re not participating, or you’re somehow missing out. That evokes emotions — negative emotions. Rather than passive investing, I call it smart investing, no-regrets investing, where I’ve minimised the moving parts and the decisions I have to make, and I’ve minimised the cost, and I’ve maximised the chance of me getting the returns from capitalism which are there for the taking.
“A passive portfolio can go down, just as well as it can go up. People talk about when stock markets are racing it’s great, but what about when they fall? Well, active funds fall the same, if not more, because of the bets that they’re taking. But rather than passive, let’s use the word smart. Smart investing. What is smart investing? It’s minimising the moving parts and maximising the amount you’re going to get from participating as an investor in capitalism.”
Broadly speaking, the case for passive investing is based on two related theories — The Random Walk and the Efficient Market Hypothesis.
Financial adviser and author Mark Hebner says: “The Random Walk Hypothesis is really crucial for investors to understand. It in essence says that the current price includes all the information we currently know and the impact of that information on the future. So the change in price in the future has to do with new information that is random and unpredictable. Nobody knows tomorrow’s news.
“So Efficient Market Hypothesis has to do again with this idea that all the known information and news is currently embedded in stock market prices. And the real implication of that is that prices are fair.”
If you agree that markets are mostly efficient and that future price movements are unpredictable, index funds are the logical choice.
But the biggest advantage of using them is the cost. You can buy an index fund for around 20 basis points. That’s another way of saying a fifth of one per cent.
With an active fund, you’re looking at an annual charge of between 75 and 100 basis points. But once you add on transaction costs and other fees and charges, you could be paying at least 200 basis points — in other words, ten times more expensive than an index fund. Over the course of an investing lifetime, that can make a huge difference.
Jason Butler says: “Every penny you pay in costs comes out of your return and reduces the impact of compounding. Initially what might seem a small amount coming out of your money each year actually has a disproportionate impact on the end result that you’re going to have. In some cases, if you’re paying, say, 1% per annum to someone to manage your money, and you’ve got a compound return of, say, 5%, it could make the difference between having £4 million at the end of the term and £3 million. You can choose your term, you can choose your investment amount and return, but the point is that small deductions from your money on an on-going basis actually have a massive impact on the terminal value that you’ll end up with.”
In the US in particular, there’ve been huge outflows of money from actively managed funds and into low-cost index funds.
In the UK too, more and more investors are taking the passive route, as concern grows about the performance of active funds, and the industry’s unwillingness to offer lower, more transparent fees for actively managed funds.
Some in the industry have warned that indexing is becoming too popular. But it’s not a concern shared by Ben Johnson, Director of Passive Funds Research at Morningstar.
Ben Johnson says: “If you look at the growth, it’s clear why these concerns have been raised because passive investing, index funds and exchange traded funds have been growing at a pace that has far outstripped the growth, which in some cases has actually been attrition, of traditional actively managed funds. Now that said, these are by definition very low-activity managed funds, so the real concern should be, who is doing price setting at the margin? Does it continue to be well-informed, well-equipped active managers, or is it passive funds that are just blindly buying securities and setting out to track an index? These low-activity, low-turnover funds are actually doing a very tiny fraction of the actual trading in securities markets, which is where actual price discovery is taking place, where prices are being set.”
Finally, what does Warren Buffett, the world most famous active investor of all make of index funds?
The answer is, he loves them. In his February 2017 letter to Berkshire Hathaway shareholders, Buffett was hugely critical of active managers — hedge fund fund managers in particular — and of the fees they charge.
“Both large and small investors,” he said “should stick with low-cost index funds.”