Investors who already lean toward the advantages of passive investing will definitely want to hear about a groundbreaking new study that’s making the rounds about the power of fully passive portfolios.
It’s already fairly clear to those who follow the passive-versus-active debate that the typical passively managed fund does better than a comparable actively managed fund. The point in this new study is that the results are more striking when the analysis comprises full portfolios, not just individual funds.
This basic idea is in focus in the Standard ' Poor’s Index Versus Active (SPIVA) data series that, give or take, tells us a similar tale twice a year; namely, that in most survey periods, anywhere from about 60 percent to two-thirds of given passive funds outperform their active counterparts .
While there are clearly exceptions, such as in the second half of last year when many government bond fund managers did better than their indexes, the passive-over-active outperformance that prevails most of the time tends to grow more pronounced over time.
The most simple explanation for the outperformance is that passive investment vehicles like index ETFs are a lot cheaper than actively managed funds, which means that active funds have to do better than index funds all the time just to climb out of the performance hole that their relatively high expenses represent.
But there’s a pure performance active aspect to the SPIVA data as well, and this new study gets at that phenomenon in a striking way.
I mentioned previously that Rick Ferri, head of Michigan-based Portfolio Solutions, and one of the better known advocates of index investing, was behind this study, and published a white paper on the findings. Ferri is quick to stress that he and his partner looked to give active funds the best showing by eliminating more expensive share classes and by steering clear of funds with costly load fees.
There were three main elements to the findings of the study—two of those will seem familiar and a third is utterly damning to those who say that active management can consistently deliver outperformance.
First, the simple hypothetical “60-40” passive portfolio Ferri chose to analyze and to size up with comparable active funds was as follows:
- Vanguard Total Stock Market ETF (VTI), 40 percent allocation
- Vanguard Total International Stock ETF (VXUS), 20 percent allocation
- Vanguard Total Bond Market ETF (BND), 40 percent allocation
The first and second conclusions of the study that spanned a 16-year period from 1997-2012 were that passive portfolios, on the whole, had high probabilities of outperforming active portfolios, and the probability of that outperformance became more pronounced over time.
The third piece is that when more active funds are added to each category—a statistical gesture aimed at accounting for so-called manager diversification that characterizes the mishmash of funds that can and do coexist in typical 401(k)s—active returns are actually hurt to a significant extent.
Ferri and his co-author Alex Benke of New York-based passively focused money management firm Betterment specifically found that their hypothetical indexed portfolio with the three Vanguard funds had a probability of outperformance over a competing active portfolio in the 83 th percentile (an 83 percent probability of outperformance), and that over time, the probability of outperformance trended higher.
To illustrate the power of what Ferri and Benke found, consider that when each of those three Vanguard funds were analyzed toe-to-toe with active funds in each respective category, the probabilities of VTI, VXUS and BND outperforming the weighted average of competing active strategies was in the 77 th , 62 nd and 91 st percentile.
In other words, the probability of outperformance for the three individual funds over their active counterparts was, except for BND, lower than the 83 th percentile probability of the whole passive portfolio outperforming the competing actively managed portfolio.
But here’s the kicker, the one I called “utterly damning” above:When Ferri and Benke compared each of the passive portfolio’s constituents with not one, but two, separate active funds, the probability of outperformance of the three-fund passive portfolio increased to the 87 th percentile. And when they added a third active fund to the mix, the passive outperformance jumped to the 91 st percentile!
The takeaway here is that in analyzing how a whole portfolio works in unison, the most important questions investors have to ask themselves is what they get paid for being right, and what they lose for being wrong.
“You could win with two out of three portfolio picks, but you’d still lose,” Ferri told me recently when we talked about the study.
Contained in that comment is an important aspect that Ferri is adamant about emphasizing; namely, that none of this means active managers can’t outperform index funds. They do, but just about a fifth of the time, according to the study. Simply put, the challenge to outperform a passive approach is more daunting when the problem is viewed holistically from the perspective of an entire portfolio.
The deeper and transcendent power of the data Ferri and Benke used is that it accounted for “survivorship bias,” which means the effects on returns of all the funds that closed during the survey period are part of the data set.
That’s huge, because survivorship bias is routinely overlooked in the analysis of returns in the mutual fund and hedge fund industries. Why? Because neglecting survivorship bias makes active management look better or—perhaps more fittingly—less bad, compared to passive investing.
Ferri and Benke got hold of data from the University of Chicago’s Center for Research in Security Prices, or CRSP, and the fact that the data only go back 16 years suggests how hard it is to get a truly clean read on the active-versus-passive debate. All I can say is thank goodness that CRSP—far from Wall Street’s self-serving sales and marketing pitches—exists to champion the real interests of most investors.
And that’s why we’ll be talking about Ferri and Benke’s study a fair amount here at IndexUniverse because, frankly, it’s terribly important. Firstly, investors need to be reminded that passive investments are cheaper than active ones.
But more profoundly, as this study lays bare, passive vehicles like index funds—and whole portfolios that are built entirely of passive vehicles—are a lot more than dirt cheap. In a probabilistic sense, they’re just a lot more sensible than the more expensive active alternatives.
At the time this article was written, the author held no positions in the securities mentioned. Contact Olly Ludwig at firstname.lastname@example.org .
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