Rick Ferri, the founder of Portfolio Solutions and a big proponent of passive and low-cost investing, stopped by the other day. He has written not just one, but six books on the subject, including one that looked at ETFs. His new book, The Power of Passive Investing, brings together a lot of thinking on the issue.

His main point is that while the occasional active investor/mutual fund will beat the market over time, the odds are weighted powerfully against that happening.

For one thing, over time a certain number of active managers fall out of the game —about a third after 10 years, lowering the odds right there of those funds beating the market. As many of you know, this is called survivorship bias. Of those remaining funds, he says, only one in three outperform index funds.

One of the most interesting findings Ferri mentioned was that mixing active and passive funds lowers the probability of a portfolio beating the market — the more active funds in the mix and the longer the period that they’re held, the lower the probability of beating the market.

Ferri showed that buy and hold with index funds actually does beat the market over time compared with tactical asset allocation.

One reason that active management fails to deliver superior returns is the high cost of trying to beat the market, he says. Investment managers and investors spend “hundreds of billions” each year trading securities, buying research, paying managers and consultants.

“The cost of trying to beat the market makes doing so impossible for most people,” Ferri says. Another reason of course is that when you chase performance by buying an actively managed fund with a market-beating history, you are always chasing past performance, and putting money where it should have been already.

Index funds, especially those from Vanguard, and exchange-traded funds have much lower costs than actively managed funds, he points out. He uses mostly ETFs in his investments and charges only 25 basis points a year investing passively and of course, rebalancing. It’s a good resource to know about for clients who might not be able to afford your services.

Of course not everyone believes this. Ferri would argue that that’s because millions are spent and made on convincing people to invest in and spend extra money on actively managed funds that purport to beat the market. Legg Mason’s Bill Miller has had an impressive winning streak and Fairholme Fund’s Bruce Berkowitz has been a steady market beater.

To Ferri, these are like the monkeys that happen to type out a script that sounds like Shakespeare. Having heard both managers talk, I must admit I’m very impressed with their expertise and wisdom and strategy going forward. But Ferri is in good company with John Bogle of Vanguard funds and Burton Malkiel, author of A Random Walk on Wall Street.

The odds of course against getting this message out are about as low as the odds of beating the market. According to Ferri, for every new book published on passive investing there are at least a dozen books published on how you can beat the market. And for every interview with a passive investing advocate like Ferri, there are at least 100 interviews with people who claim they can beat the market.

Perhaps part of the problem is that if everyone just invested in index funds and ETFs, the world of investing would be a lot less interesting. Just as bad news sells in the media, so does a sexy stock strategy is a lot more interesting than a boring old index fund portfolio.


Register or login for access to this item and much more

All Bank Investment Consultant content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access