It's a truism that the average investor (i.e. one who doesn't get paid to pick stocks) is better off putting his money into a passive index fund than paying a pro to choose stocks for him. Once you factor in the extra fees actively managed investment vehicles charge, actual returns wind up being lower than what an index would provide -- and reinforces the notion that it's really hard to beat the market.
But Alex Savov, a doctoral student at Booth, the University of Chicago's business school, provides an interesting new take: He argues that active and passive investing actually turn out to provide the same returns. And the reason isn't because active managers are better than we'd previously given them credit for; it's that average joe investors have a terrible go at timing markets.
The following chart from Savov shows that money movements into and out of index funds are quite cyclical--passive investors tend to buy high and sell low--while flows for actively managed funds are more stable. (The chart shows the share of total stocks held in index (blue) and active (red) funds.)
When you factor retail investors' horrible timing and active funds' (relatively) good timing, the buy-and-hold advantage of index funds seems to disappear:
"The broader message is that performance evaluation should consider the end returns earned by investors and not simply buy-and-hold returns."
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COMMENTS (4)
One thing the paper doesn't seem to account for is drag due to taxes. The higher churns in active funds often depress long term returns due to more taxes owed each year which hurts some of the compounding effect.
One thing the paper doesn't seem to account for is drag due to taxes. The higher churns in active funds often depress long term returns due to more taxes owed each year which hurts some of the compounding effect.
During his rehabilitation, Henry Blodget did a series over on Slate that argued essentially the same thing. Pro's had better instincts than Shmoes when it came to timing stock buys. And concluded that low-load mutual funds/passive index funds were the best choice for the average buyer. More confirmation of Savov's work.
During his rehabilitation, Henry Blodget did a series over on Slate that argued essentially the same thing. Pro's had better instincts than Shmoes when it came to timing stock buys. And concluded that low-load mutual funds/passive index funds were the best choice for the average buyer. More confirmation of Savov's work.
This doesn't look to be an advantage of active fund managers, but a problem with index-fund investors. Holding fund flows equal, the passive strategy still beats the active one. The problem here is that what Savov is comparing isn't really active vs. passive investing, but two different kinds of active investing. Market timing is every bit as "active" as stock picking, and a hard-core indexer [say a Boglehead] would regard both with equal contempt. What we seem to have here is a lot of "hot" money flowing in and out of index funds, not out of an understanding of the strategy, but simply seeking "hot" returns. Calling that behavior "passive investing" is deeply misleading.
This doesn't look to be an advantage of active fund managers, but a problem with index-fund investors. Holding fund flows equal, the passive strategy still beats the active one. The problem here is that what Savov is comparing isn't really active vs. passive investing, but two different kinds of active investing. Market timing is every bit as "active" as stock picking, and a hard-core indexer [say a Boglehead] would regard both with equal contempt. What we seem to have here is a lot of "hot" money flowing in and out of index funds, not out of an understanding of the strategy, but simply seeking "hot" returns. Calling that behavior "passive investing" is deeply misleading.
After reading Savov's introduction again, I need to be clear that the low cost index fund is the better choice for investors (which Blodget was on to too).
After reading Savov's introduction again, I need to be clear that the low cost index fund is the better choice for investors (which Blodget was on to too).