Passive power

John Osbon - April 2, 2013

People often refer to index-based investing as “passive” investing. Some view that label as a negative – as if that investment style is somehow weak, unsophisticated, or the refuge of the lazy.  I disagree completely.  And I’ll tell you why.

Index based investing, using ETFs (exchange traded funds) to invest in diverse markets, earns its p-word moniker. Index ETFs simply duplicate asset classes –stocks, bonds, real estate, and so on. Almost no daily activity is required to operate an ETF, in contrast to active investment. Active managers, forever hoping to time the market or find hot securities that will beat the market, typically make many more trades than passive managers.

Most passive moves are meant only to keep an ETF in line with the index it tracks.

Invest like Mother Nature

Passive investing is simpler, but does that make it weak? I’d look to nature for the answer. The wind, tides, and sun are passive – they exert huge forces without anyone doing anything.

Index investing is the same idea – lots of power with little effort. With minimal trading and no forecasting of unknowable future events index investors simply reap index returns over time.

What kind of returns?  Index returns!  As the 2013 Andex chart points out (send me an email for your own copy), large US stocks have compounded annually at 9.8% since 1925.  Small US stocks have done ever better at 11.9 percent.  Long term government bonds come in at 5.7 percent, and 30 day T-Bills at 3.5 percent. Inflation, by comparison, has averaged about 3 percent.

Yes, returns can be far higher or lower over shorter periods, (for instance, the Dow Jones Industrial Average produced a total return of 11.93 percent in the first quarter of 2013; hedge funds averaged 3 percent) but over long time periods, we generally see what mathematicians call “convergence to the mean,” – returns cluster around long-term averages. For investors, I’d call convergence a force of nature in itself.

But can’t we do better?

Some critics of passive investing would argue that earning market returns with indexes is mediocre. I guess I would agree if most mutual fund managers beat the benchmarks. But they don’t.

The SPIVA Scorecard from S&P shows that benchmarks beat 66 percent of domestic equity funds in 2012, 74 percent of funds over the last 3 years, and 69 percent of funds over five years. Empirical data shows more clearly each year that active managers, on average, underperform benchmark indexes – the same kind of indexes that ETFs track.

Of course index funds have a big advantage. With few trades, no analysts picking hot stocks, and no economists and forecasters to pay, ETF expenses are far lower than actively managed funds. That means more money goes into the investor’s pocket. See “Cost is boss when it comes to performance.”

The performance and cost results have been good news for passive for some time as we pointed out in our recent post on Vanguard: “Play to win”.

Passive and proud of it

To put passive power to work, I established Osbon Capital in 2005.  As a compounding machine for individual clients we have grown like an oak – sturdy, strong and steady.  I attribute our success to goal-based asset management via diversified, tax-efficient index investments, without the cost burden and wild goose chases of active management. That’s passive power at work.

John Osbonjosbon@osboncapital.com

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