Our long-time readers are well aware of our skepticism toward “active” money managers; those who seek to outperform the overall stock market by picking “mispriced” stocks or by attempting to time the market’s gyrations. Our recommendations are instead based on the tenets of Modern Portfolio Theory (MPT) and the notion of market efficiency. Active managers who have managed to outperform the market have done so only by chance, or by assuming greater risk than that posed by the market.
But there is a way to “beat the market.” Simple logic dictates that an investor who chooses to hold a passively managed, market-cap weighted index of the entire U.S. stock market will earn net returns that, in fact, exceed those of the rest of the market. After all, if an investor holds such a portfolio, the aggregate of all other investors’ portfolios must also comprise the market portfolio. The returns, before fees and expenses, earned by the passive portfolio will equal those of the market-cap weighted average of all other portfolios, since both provide market returns. Therefore, when the fees and transaction costs of active management are accounted for, the (net) returns of the passive investor must be higher.
John Bogle, founder of the Vanguard Group, put it most succinctly:
“Whether markets are efficient or inefficient, investors as a group must fall short of the market return by the amount of the costs they incur…Even for investors who incur more modest costs (say, 1% per year), the odds are that 95% of them will fail – often by huge amounts – to earn the stock market’s return over an investment lifetime.”
Ken French of Dartmouth’s Tuck School of Business recently quantified the cost of active management. In his study French found that an average investor pays 0.67 percent per year by choosing active management rather than simply embracing the market’s returns. This is the cost the typical active investor can expect to pay for the privilege of being able to earn, on average, the market’s rate of return. Over short periods some will of course outperform the average (just as some will underperform), but none can do so consistently.
Yet hope springs eternal. At the end of 2007 only 12.7 percent of mutual fund assets were held in passive funds. Apparently the remaining 87.3 percent remains in the hands of active investors, each of whom is convinced that everyone else is foolish, and that they possess a special ability to exceed the generous returns of the capital markets that are there for the taking.
Also in This Issue:
What Medicare Does and Doesn’t Cover – And How to Fill The Gaps
Indexed Annuities: Don’t Be A Victim
Immediate Annuities: Retirees Beware
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles
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