Why Passive Investing Works

It is well-documented that the vast majority of investors, whether financial advisors, hedge fund managers, individual investors, and even day traders, underperform the market. This may or may not come as a surprise to you, but it is fascinating to me. An entire population of people devotes years of their life to a craft that yields no results. Welcome to the world of active management.Passive Investing – Dont Try To Beat The Index…

Active management is the practice of intentionally trying to beat the market. This occurs in all aspects of investment management, the stock market, the bond market, futures, options, etc. As with anything else in life, there is a trade-off for every decision that you make. If you want a promotion at work, you will have to work for it. Whether that is working extra hours, taking on additional responsibilities, or going back to school, the cost must come from somewhere. The same is true when it comes to an investment strategy. If you want abnormal returns, you will have to take on some form of risk. The more risk you accept, the higher the expected return. Is this truth universally applied? Yes, but there are exceptions. Sometimes (and infrequently), the perfect investment opportunity will come when an outsized gain is achieved with minimal risk. But these happen rarely.

Active Investing

Active portfolio managers are investors trying to outperform indices. They are constantly looking for opportunities where the expected return is greater than the assumed level of risk. The number of active investors searching for these opportunities has increased exponentially throughout the years that it is nearly impossible to find these rare gems. Thus, the markets have become very efficient, some more than others. This means that any time any news breaks regarding a certain company or sector, those assets’ price immediately reflects that news.

For example, let’s assume that Apple, Inc. (AAPL) reports manufacturing trouble. The news would send the stock price down almost immediately, simply because Apple would now receive reduced future cash flows due to the manufacturing troubles. Because there are so many investors (and machines) scanning the newswire for information like this, it is challenging to make a profitable trade under this scenario. The low-hanging fruit opportunities, at least here in the U.S., are extremely difficult to identify. Most managers fail to find them. As such, Bull Oak Capital advocates passive index investing for most asset classes as most markets are efficient. However, there are some active managers that can add value.

Active Investing is Hard

Is it at least possible for you (or an active fund that you own) to beat the index? Of course, it is, but it depends on which market you are playing in, your access to key information, your skill, and your luck. There are plenty of famous investors that have made a career of picking stocks, such as Warren Buffett, John Templeton, Stanley Druckenmiller, Cathie Wood, and others. However, they are in the extreme minority. Most investors do not fare so well. According to a SPIVA (S&P Indices Versus Active) study, 84.2% of active managers here in the U.S. underperformed the large-cap index.

US 2017 SPIVA

In other words, for every 50 active investors, only 7 beat the benchmark. For a more thorough look into the other asset classes here in the United States, please see below. The theme of underperformance does not improve.

US all cap SPIVA

International Markets A Little Better

If we look at the international markets, we can clearly surmise that those markets are not nearly as efficient as the United States, meaning that there is still some opportunity for active managers to add value. However, picking an active manager that will outperform is still less than 50%, not great odds.

Mexico 2017 SPIVA
Japan 2017 SPIVA
Europe 2017 SPIVA
Canada 2017 SPIVA

What About Past Performance?

Most investors look at a manager’s past performance when determining whether or not to invest. One of the most important measurements is whether or not the manager can deliver above-average returns over multiple periods. However, outperforming over time, has also proven to be difficult.

“An inverse relationship generally exists between the measurement time horizon and the ability of top-performing funds to maintain their status. It is worth noting that less than 1% of large-cap funds and no mid-cap or small-cap funds managed to remain in the top quartile at the end of the five-year measurement period. This figure paints a negative picture regarding the lack of long-term persistence in mutual fund returns.” (S&P Persistence)

Active Management Underperforms

As many of you know, Bull Oak Capital invests in passive index ETFs because of this data. The odds of outperformance at the sub-asset class level is low. Many managers will argue that they can exploit inefficiencies in the stock and bond market and capture that value (alpha). Perhaps they can, but most cannot. For those that have, I have a few questions:

  • Can you recreate your methodology and be able to capture that value year-over-year in a consistent manner?
  • How much of that outperformance (if any) is due to skill versus luck?
  • Are you simply riding momentum or are you style drifting?

The truth is that most individuals can’t tell whether or not a fund manager is skillful or lucky. Persistence is one important measure to test this, but not the only one. It is better not to play the game at all to keep your pocketbook and sanity levels high.

What We do

Our investment strategy at Bull Oak Capital provides 5 investment portfolios for our clients, ranging from Conservative to Aggressive. All of our clients are invested in one of these strategies. We purchase broad index funds from the global markets, including domestic stocks, international stocks, Treasury bonds, corporate bonds, etc. Our investment philosophy is one that is rigorously backtested using UCLA academics.

We are not for everybody. And we know that not every investor is a good fit for us. For investors looking for a long-term portfolio that will take advantage of global economic growth, we are a great fit. We are not a great fit for those looking to make a quick buck and those looking for the next stock tip. We act as a financial partner to our clients, ensuring that they take the necessary steps to achieve their financial goals.

Bull Oak offers transparent San Diego financial services. Our goal is to ensure that our clients investing in San Diego are well educated on our passive investment strategies. We collaborate with them to determine a risk tolerance portfolio that is right for them.

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