Passive Funds Have Ruled the Roost Over the Last Decade

Passive Funds

Some may think that an actively managed fund should at least beat the market, because this is what we pay them more for. 78% of them fail to even do this.

It’s pretty common knowledge these days that about 8 out of 10 active funds fail to beat the market, in spite of all the resources that they commit to doing so. Active funds are still the most popular way to go though, although the word is getting out more and passively managed funds, which just track indexes and involve zero decision making, have caught up a lot and are poised to take the overall lead soon.

Just so that we can be more precise about this, Barron’s studied the performance of all larger funds over the last 10 years and found that only 22% of funds beat the market, with “the vast majority of them” being growth funds.

This is no great revelation, as we have plenty of other data to support this conclusion, and whether or not the lead is 80 to 20 or 78 to 22 isn’t really meaningful, as active funds lose big in both cases.

Breaking this down by growth funds and so-called value funds is informative though, although we would also expect such a distribution. Growth funds actually seek growth, and if you are seeking to grow faster than the market, you will at least have a better chance of doing it than if you are not seeking growth.

We’re not even sure what value funds seek actually, and the best that they can come up with is a belief that value funds will take over someday. When we look deeper into these beliefs, we see a view that has simply detached itself from the realty of stock investing and the rationale boils down to something similar to saying something is so ugly that it is beautiful.

There are surely some out there with such odd tastes that they find the ugly beautiful, in spite of the contradiction involved, but stock investing is not subjective, it is objective. The ugliness here has come from some ugly objectiveness that requires that the ugliness go away objectively before it can no longer be called that, allowing for these ugly ducklings to have an opportunity to swim with the swans again or for the first time.

Barron’s even warns that people should not simply prefer growth stocks after reading their article. That’s as far as they go, and it’s not made clear at all how this might happen, aside from some magic wands being waved such as the one that turned Cinderella into a princess for a time.

We don’t want to just let beliefs stand naked like this though, and if you are invested in a fund that selects stocks based upon their lack of performance and potential and prefer these over the good stuff, and then sit back and hope that someone uses enough magic on them to turn them into princes and princesses, that’s not a lot to go with and certainly nothing that anyone should bet their money on.

When someone tells you to go with bad stocks, the fact that one day they may not be bad is not a good reason. Investing requires analysis, not just dreams and hopes. When the actual analysis says no but you say yes, you are asking for poor performance and this is a wish that you can count on being granted, by the gods of probability.

You want to do your best to have the gods of probability on your side when you invest, and we certainly do not want to go with a low probability of success and a high probability of failure because this is just not a good bet at all. If we can double our money a tenth of the time and lose it all nine tenths of the time, only a true fool would take this bet, but when we cloak it with the term “value investing,” we can easily be blinded by the actual odds, especially if we don’t even look at them, which this requires actually.

If We Want to Beat the Market, We Need to Want Our Stocks To Grow More than the Market

Even if value funds somehow ended up outperforming growth funds over a long enough period to be noteworthy, we could of course switch to them then. This is not like for richer or poor and in sickness and in health, as we only want to stay in this kind of marriage when we are richer rather than poorer and in health rather than sickness.

Right now, growth funds are richer and in better health, the sort of thing we like, but we need to keep an eye on this so that we may change sides when the grass actually does become greener elsewhere.

This cannot possibly be a valid objection to going with growth over value, a minimal chance that somehow this approach may end up working out better someday even though it would be foolish to jump the gun and be anywhere this presumptive, although the fact that growth funds tend to be riskier may be more convincing, at least on its face. If we are worried about this, and we definitely should be, the ring does come off and when it squeezes us too much, that’s exactly what we should be doing, and wear it again once the relationship improves enough to restore our confidence once again.

Growth funds therefore at least distinguish themselves better against what works out to be the ultimate goal of funds, to beat the market, and from the data we know that they fare better than this 22% overall success rate at this, because this is weighed down by the much poorer performing value funds in the mix. When we take them out, the odds at least improve for us.

We can further refine this by looking at a number of different things, with funds run by certain companies tending to do better, funds investing in certain sectors outperforming others, certain stocks being more reliable for this, and so on. We do want to make sure that we don’t just chase returns though, and the hot fund of today may cool off for a number of reasons and a laggard may pick things up, merely by way of vagaries. We see this quite a bit among funds, especially when you compare shorter term results such as just a few years.

As a general rule though, stocks with the potential for more growth tend to grow more, and the potential for growth isn’t just a big factor in a stock’s price, it’s actually the whole thing. This is why people pay a big premium for stocks with a lot of potential, even ones losing money right now, but they will pay a lot less for those who are stuck in the mud, the value plays in other words.

If we tried to emulate what an active fund does with our own accounts, we’d have a much easier time of things because we don’t have to worry about the huge amount of slippage that funds have to deal with. Funds, because of the size of their investments, are forced into a contrarian position a lot of the time where they have to trade against the momentum of a stock to try to reduce this slippage. We therefore see these funds buy a lot more dips and sell a lot more into strength than anyone would ever want to if they had the choice, and this both limits return and increases risk.

It’s not hard at all to pick stocks that will outperform the market, and you could even train a child to do this with not a lot of instruction. If we can’t move in and out of them the way that it would make sense to, that’s going to be a big challenge, and this is the biggest reason by far that funds that are actually seeking to beat the market so often fail to do so.

There are also costs involved in managing a fund and this always puts a fund behind an index where an identical performance will put the fund behind the market by this much. This is a lot bigger number than just the 1% that you may pay in management fees. We’re actually left to guess at the overall number because it’s not so easy to define what a fund’s slippage costs are as it switches positions, the thing that it is paid to do and what distinguishes them from passive funds.

You don’t just have to beat the market straight up, you have to beat it by enough to make up for these costs. All of the slippage you encounter will count against you and must be overcome by way of skill, by seeing the benefit of being in above average performing stocks exceed the cost of seeking this.

Beating the Market Ourselves is a Whole Lot Easier than Funds Doing It

This requires us to pick better stocks and also time them better to win at this game, and it’s not hard to see why only 1 in 5 funds end up doing this, and those that do this consistently, and some do, really deserve to be congratulated as this is a lot harder than people think.

Passive funds at least hedge against the risk of riding the wrong horses, which is significant enough to need to account for at least. As always, this needs to be about probability, and we should not be preferring situations that involve us accepting inferior odds overall.

Whether a particular growth fund has actually bettered the odds over a passive funds is a matter of analysis, and the many who have simply chosen not to bother with any of this and just invest in index funds instead can hardly be blamed.

If we are feeling particularly ambitious, we can take a shot at doing this ourselves. Given that a passive fund is basically random where we only need a little advantage to beat them, this isn’t that hard and is also a task that isn’t that easy to screw up, and is far less dangerous than a lot of people assume it is. We may not want to put all our eggs in play with this, and should seek to balance such a strategy with an index fund to add stability should we desire it, but do-it-yourself investing is not a crazy idea at all and doesn’t require a whole lot of skill, although it does require some.

The thing we want to avoid here is flying on the seat of our pants too much where we end up overtrading a lot, things like buying a good stock and selling the first pullback only to see it go up further after we’re out, or selling something when it is doing too well to make that a good decision.

The fate of our portfolios is just too important to not pay any attention at all to trying to help ourselves. We need to make sure that whatever decisions we make, including ones that involve not making any at all like an index fund does, are well thought out, and involve more than just hearing a tune and dancing along with it, no matter how big of a hit the song might be.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.