The Power Of Passive Investing

April 20, 2011

Putting It All Together
Figure 5 quanti?es four portfolio management choices and is overly generous to active investors. Investors who use low-cost index funds and ETFs and strategic asset allocation earn market returns. Investors using actively managed mutual funds lose about 1 percent over index funds, and investors who employ tactical timing strategies lose another 1 percent. Investors who use both active funds and a tactical asset allocation strategy are expected to underperform an all-index fund strategic allocation strategy by about 2 percentage points per year.

Disciplined passive investors are smart-money investors. They follow a long-term strategic asset allocation strategy based on their needs and ?ll their portfolios with low-cost index funds and ETFs to represent those asset classes. They don’t mistakenly believe that they have the skill to pick outperforming funds and know they don’t have the timing skill to rotate in and out of different asset classes and sectors.

Many investors use both a strategic allocation and a tactical allocation. This strategy has been called core and explore, core and satellite, barbell, core plus and a variety of other names. The idea is to place part of the portfolio in a strategic asset allocation using index funds and ETFs, and then play with the remaining part of the portfolio using tactical asset allocation.

I call these combined strategies core and pay more because that best describes the outcome. The cost of the explore side is more expensive than the core side, and there’s no reason to believe that the active management results will be any better simply because there is less of it. Investors will likely earn market returns for their passive positions in index funds and below-market returns in that portion using tactical asset allocation.

Investment returns for a passive strategic asset allocation are much more likely to earn superior returns than those earned from tactical asset allocation strategies. The nuances of strategic and tactical asset allocation strategy go beyond the scope of this exploration.

A high percentage of new money ?ows into asset classes, sectors and styles that have had recent high returns. This trend-following behavior likely results in a loss of more than 1 percent per year in investors’ portfolios. For active fund investors, the timing gap loss is in addition to the shortfalls from the actively managed funds they buy.

Passive investors outperform those who attempt tactical asset allocation. Through regular rebalancing, passive investors bene?t from the mistakes of people who follow the crowd into past outperforming sectors. A passive strategy using index funds and ETFs that is followed religiously provides investors with the highest probability for investment success.

This article was lightly edited to reflect the editorial conventions of the Journal of Indexes.

Copyright © 2011 by Richard A. Ferri. Reprinted with permission of John Wiley & Sons, Inc.

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