What the Experts are Saying

“Vanguard has a culture of integrity and low fees,” says Levitt. “And I recommend low-expense-ratio index funds. If I preach it, I ought to practice it.”

– Authur Levitt, former Securities and Exchange Commission Chairman.

“Most of my investments are in equity index funds.”

– William F Sharpe, Nobel Laureate in Economics, 1990.

Management Overview

Investment management can be generally broken down into two different philosophies:

Active management

Active management involves timing the market, guessing which industry and sectors will outperform others and actively buying and selling securities that are expected to go up and down. 

Passive management

Passive management, also known as indexing, is based on the belief that the Efficient Market Theory is generally true and that after trading expenses, taxes and management fees it is virtually impossible for an active manager to beat the overall market over a long period of time. 

The Efficient Market Theory

The Efficient Market Theory explains the process of free and efficient financial markets. First, information about stocks is widely and inexpensively available to all investors. Second, all known and available information is already reflected in current stock prices. Third, the price of a stock agreed on by a buyer and a seller is the best estimate of the true value of that stock. Finally, stock prices change almost instantaneously as new unpredictable information appears in the market. All of these factors make it nearly impossible to capture returns in excess of a market return without taking greater than market levels of risk. The only issue of concern is the relationship between risk, return, time, and correlation.
Passive investment management makes no attempt to distinguish attractive from unattractive stocks, or forecast stock prices, or time markets and market sectors. Passive managers invest in broad sectors of the market, called asset classes or indexes, and, like active investors, want to make a profit, but accept the average returns various asset classes produce. Passive investors make little or no use of the information active investors seek out. Instead, they allocate assets based upon empirical research delineating probable asset class risks and returns, diversify widely within and across asset classes, and maintain allocations long-term through periodic rebalancing of asset classes.

Active investors must overcome many costs to match the returns of the average passively managed portfolio. These include trading costs, much higher management fees, market impact costs as active managers affect the prices they pay, dilution from maintaining higher cash positions than passive managers, taxes in taxable accounts due to high turnover rates, and, commissions, if an investment is purchased through a broker or financial salesperson. These costs create a significant handicap for the active investor that is extremely difficult to overcome. The least expensive forms of active management, no-load mutual funds and wrap fee accounts, typically consume 2.5% per year from investor's returns, while passive or index portfolio costs are typically a small fraction of this. A 2004 study of 1,446 large capitalization mutual funds showed that over the previous ten year period only 2% were able to beat the S&P 500.

High turnover creates short-term capital gains in a mutual fund or a portfolio of individual stocks. In taxable accounts this can create an insurmountable barrier to beating an index. The average mutual fund turns over ninety percent of its stock each year. This high percentage forces the distribution of capital gains by the fund, which become tax liabilities for the fund’s shareholders. Active investors incur far greater federal and state taxes, since almost all of the capital gains are short-term and are taxed up to forty-six percent. On the other hand, index fund investors buy and hold, so they rarely incur capital gains. When they do, they are long-term gains that are taxed at a much lower rate. The relatively new Exchange Traded Fund (ETF) structure allows for in-kind exchanges of stocks to create very tax efficient investment instruments.

Investment returns are far more dependent on investor behavior than the performance of the investment. Investors generally make bad decisions under the pressure and stress of trying to outperform a market. These shortfalls are directly attributed to investors overreacting to constantly changing conditions in financial markets, resulting in brief holding periods for mutual funds. The tendency of investors to bail out of stock funds during market downturns and buy back in too late when the markets recover obviously harms performance. In fact, trading patterns analyzed by a Dalbar study showed that most investors invariably buy high and sell low. The more an investor buys and sells mutual funds, the lower the expected return. All these findings were also true of bond fund investors. According to the study, a buy-and-hold strategy outperformed the average investor by more than three to one after ten years.

When the stock market performs well, as it did for most of the 1980's and '90's, investors are more prone to believing they can beat a market. When they get lucky and make a profitable investment call more than once, they are lured into thinking they are successful market forecasters. Unfortunately, this false sense of confidence leads them to the poorhouse.

Active investors, like casino gamblers, often do not account for their total return properly. Common mistakes include the exclusion of loads, commissions, taxes, and cash flows in and out of their portfolios. Another common error is quoting the returns of only the portion of their portfolios that performed well. Then there is the problem of hearing only from the winners and not hearing from the losers who seem to disappear into thin air. Since 1961, more than twenty-five percent of mutual funds have vanished from the record. There is no accounting for their returns.