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10 reasons why passive beats active investing

Passive vs Active

Passive investing typically beats active over the long run. You are probably wondering:

What is passive investing?

Passive investing is a long term buy and hold strategy where that tracks an index or a basket of indices. An index is a basket of stocks that is used to track the progress of the overall market, sector or theme (for example: NIFTY or SENSEX). The idea is that individual stock picking has a 50/50 chance of doing better or worse than the market. When you add to that the ridiculously high fees that you pay every year for individual stock picking you get an active investing product that consistently underperforms the market by the amount of the fees.

Comparison of Passive versus active investing

Passive investing beats active managers

How passive investing beats the active managers

  • Fund manager dependence – Typically an active fund’s performance depends on the fund managers ability to beat the markets. Now this ability is found in very few people – case in point is that even Warren Buffet (arguable the greatest stock picker of all time) says that his estate should be invested in a cheap (read low fees) index ETF. His partner, Charlie Munger, says that there are very few managers worth paying for for active managers and that index investors are likely to beat the vast majority of investors. The other big issue with this is that when a fund does well people start hearing about it and investing lots of money into it. Beyond a point the active management strategy loses its returns and this point is rarely figured out by the active manager. In the passive investing strategy the fund manager dependence is ZERO – because there is no fund manager. There is a well publicized index that you own.
  • Trading cost – Needless to say that active managers end up spending lots of money on trading because they are trading in and out of various stocks. Excessive trading reduces returns as lots of money ends up in the pockets of the broker. Moreover, in India, many mutual fund houses have their own brokerage that they could be trading with – and the excessive trading just drives up their fees. The trading cost of the passive strategy is very low because once bought only minor rebalances are done over the life of the portfolio until a withdrawal is made.
  • Emotion & bias – It is well known that most people are emotional and have some bias in some direction or the other. It is very difficult for us emotional beings to remove our biases. The fund manager is no sage – she also has her set of biases. Imagine if the manager while driving to work has to put up with lots of traffic jams. Would the investment decisions taken by the manager really be accurate that day? Conversely, in the passive investing strategy, there is no emotion or bias. The money just sits in the index stocks without any decision making hampered by traffic jams.
  • Performance relative to benchmark index – Active managers underperform benchmark indices. As a case in point please see the chart here that shows that majority of the active funds from 2003 till 2012 consistently underperformed the index. The passive investing philosophy makes you invest in the index – so that underperformance is only due to tracking error – which typically is very small (within 0.05% per year).
Active funds beating the S&P 500 in the US by year

Active funds beating the S&P 500 in the US by year

  • Fees & cost – The fee on mutual funds is ridiculously high – in India funds are allowed to charge up to 250 basis points (2.5%) per year. Imagine what you could keep if you did not have to pay that massive amount each year.

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