Passive Investing: Beat the Aggressors at Their Own Game

There are compelling reasons for folks who dare to be average to consider index fund investing: simplicity, low-cost, good quality, diversification, and year-after-year yields approaching that of the broad market.

I dug this week’s blog topic out of the archive because it focuses on important points of why passive investing is a good approach for smaller investors – particularly those who deliberately choose not to spend much time with their investment portfolios. There are compelling reasons for folks who dare to be average to consider index fund investing: simplicity, low-cost, good quality, diversification, and year-after-year yields approaching that of the broad market. The results speak for themselves compared to a more active management approach.

Don't Worry, Be Passive

For years, I’ve been beating the drum about investing in index funds (called passive investing) and caterwauling about “daring to be average”. Well, in the last decade or so, it has become quite the rage… not because of my caterwauling, but because it simply makes sense to investors who wish not to spend much time fussing with their retirement accounts. Passive investing has stood the test of time by consistently outperforming most active fund managers who – bless ‘em – go to extraordinary lengths researching companies to determine where to place client dollars. Some are good at it… some are less proficient. In any case, extensive research is expensive to conduct and is a cost the investor ultimately absorbs.

Beating the Big Boys

A while back, I read a Wall Street Journal article about a fellow out in Nevada named Steve Edmundson, the investment chief of the Nevada Public Employees’ Retirement System who, all by his lonesome, out-performs many pension funds staffed by hundreds of employees. What’s his secret? He invests in low-cost funds that mimic indexes. A more recent WSJ article noted that Steve managed $35 billion or so in passive funds whose yields as of June 30, 2019, for one-year (8.5% vs 6.7%), five-year (7.1% vs 5.5%), and 10-year (9.9% vs 9.1%) periods beat one of the nation’s largest public pensions, Calpers, that hires hundreds of people to invest hundreds of billions of dollars. Edmundson’s minimalist approach is based on the simple concept of “reducing the complexity, risk, and costs of a portfolio”.

Let 'Er Ride

Another more well-known fellow, multi-billionaire Warren Buffett (often called the Oracle of Omaha… the so-called greatest living investor) is also an adherent of the passive investment approach despite his Berkshire Hathaway follies (humor). Rumor is that he instructed the executors of his sizable estate to “put 10% in short-term bonds and 90% in a low-cost S&P 500 index fund and "let ‘er ride.” In short, the Oracle advised his executors to avoid the high-cost financial geniuses (Wazoos, I call ‘em) and instead, dare to be average with his piddling (more humor) estate.

The Danoff Effect

Of course, no single investment strategy is perfect – or without risk – but some tend to perform better than others over time. And there are some highly competent active managers out there. Take Will Danoff, the manager of Fidelity Investments’ huge Contrafund. Since 1990 and through October 2016, Danoff outperformed the S&P 500 Index by 2.9% per year (sources: Morningstar, Inc., and the WSJ). If you had hooked up with Danoff and invested $10,000 in 1990, you would have has around $230,000 in your account in 2016. For comparative purposes, the same $10,000 invested in an S&P 500 Index Fund would have topped out at $118,000 over the same period. During that period, Danoff was about as close to a sure thing as there was – but of course, there are no sure things. Problem is, locating the Danoffs of the world while they’re on a hot streak is a matter of good luck rather than skill.

Studies Show…

Studies show that passive (index) funds do outperform most active fund managers, but it’s not the 90% outperformance stat you often hear. Sixty percent would be more like it on average… higher in good times, lower in bad times. In short, active managers seem to do a fairly good job of preserving capital in bad times while passive funds tend to outperform active managers in both bad and good times. Why is that? Well, passive funds give investors a jump start on actively-managed funds because they are cheaper to own (lower annual expense ratios) and are more tax efficient due to less trading.

Passive investing is not for everyone, but it sure fits this old duck. I like those low annual operating expense ratios and the tax advantages associated with less turnover versus active management costs. And like Steve Edmundson out there in Nevada, I don’t need co-workers. All I need on my desk is a uniball pen, a stapler, and a $3 calculator (okay, so I overpaid). Oh, by the way, I also avoid watching CNBC and those other frenzied cable news network programs. Used to watch Fox on Saturday morning until the network dropped those four consecutive 30-minute taking-head shows and turned the time over to Cavuto. Two hours of “thank you very, very much “ of Cavuto can wear on a man.

Harvard's Embarassment

And to make my point about over-paid Wazoos, in a 2016 article by Nicholas Vardy titled “How The Nevada State Pension Fund Is Embarrassing Harvard," he noted that Edmundson earned $121,121 managing the Nevada fund in 2015 while Harvard Endowment’s ex-CEO knocked down $13.8 million… yep, $13.8 million… the year before. Edmundson’s Nevada Pension fund was roughly equivalent to Harvard’s endowment, then about $35 billion. Nine years after reaching its $35 billion peak in 2007, the Harvard endowment remained stuck in that same range. Yeah, we’re talking old news here, but it tells the tale.

Near Perfect

In summary, I, like most index adherents, believe that the stock market is an extremely efficient mechanism for properly valuing the worth of index fund companies over time. Think of it this way. Millions of very smart folks collectively gather all the information there is to know about publicly-traded companies and their prospects. This consensus of opinions quickly adjusts valuations based on constantly changing variables.

This consensus of opinions isn’t perfect, but by golly is it hard to outwit! And by investing in index funds, I don’t have to pay for it.