150- Why Passive Investing Should Be Your Gold Standard

In this episode, Benjamin explains why passive investing is actually an active investment decision based on sound evidence rather than conjecture. The active versus passive debate is all around us, and often, passive is framed as the second-best option. The reality, however, is that it couldn't be further from the truth. Evidence and history do not lie. 

Here's a link to the SPIVA analysis Benjamin referred to in the show. 

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Disclaimer - please note that nothing in this podcast can be relied upon as financial advice and the content is provided purely for information and guidance purposes. Please seek independent, regulated financial advice relevant to your situation.

Transcript

0:11

Hello money nerds and welcome. We have reached episode 150 of Heads Up on Money. I can't believe it. Thank you so much for joining me on the journey. My name is Benjamin Mitchell and every personal finance Friday. For the best part of the last three tax years, you've let me drone on at you about financial planning and why everybody should be doing it well and why we're almost educated to think that it's overly complex and reserved for only for the uber wealthy, but that's not the case. Financial planning is for everyone, and I really hope that heads up on money has gone a long way to helping you on your financial journey. If I can ask a very quick favor of you before I get into this episode, if you have in any way got any type of value from me over the last three years and haven't yet, please do like, subscribe, and leave me a comment if you're listening on Apple Podcasts, because it really helps to get the podcast to more people. I really, really appreciate it. So thank you, genuinely, money nerds. Thank you. So in this episode of Heads Up on Money, episode 150, I thought I would do a bit of a deeper dive around the ethos of passive investing and why I think the label passive is not the best name we have for this type of investing, because passive sounds like a bad thing. It sounds lazy, it sounds sleepy, it sounds second best in comparison to the alternative, which is active investing. If you're not sure what these terms mean, then here's a quick rundown that I'll get into first. But if you stick around to the end of the podcast, I'm hoping you will understand more around what passive investing actually is and why. It does not mean taking a back seat and accepting sub-performance, but in every respect it could be the best decision you've made with your investment journey. But active versus passive. So an active fund management strategy typically will involve you using fund managers who are actively trying to outperform their benchmark or market index. So these fund managers, they're trying to be clever, they're trying to add value to you to justify their exorbitant fees. But the reality is, as you know by now, money nerds, timing the markets and almost adding some form of value as a fund manager is absolute BS. And the data doesn't lie when we look into this, and I'll go into it a bit more later in this episode. But the reality is the fund managers rarely beat the markets that they're trying to beat. In other words, if they just left things alone and let markets do their natural thing, the returns would have been better for their end clients. And of course, it's a double whammy because you, as an end client, have paid higher fund management fees to get that sub-performance. It's a miracle how often fund managers are asked how they run their money. Do they invest in the same esoteric fund that they're running on a day-to-day basis as part of their job in reality? The answer is no. Most of them have got a very vanilla, plain, passive, long-term buy and hold investment strategy for their wealth. But that is not a bad thing when I say they've just got that. It makes it sound second best, but in reality it's far, far better. And I want to educate you in this episode of Money Nerds as to why passive is not the second best option. Going into the details, a passive strategy is at the other end of the spectrum, whereby a fund manager, fund house, rather than trying to actively outperform the markets, they just seek to replicate the market in its entirety. So they will hold allocations within their fund that mirror the general market. So as a result, when markets go up, the fund will go up, and when markets go down, the fund will go down. And pretty much, other than a small tracking error and their fund management fees, which are typically lower, far lower than active fund managers, you can expect that their performance is going to be pretty measured in comparison to the market. So if, as I said, the market does well, you will do well. If the market goes down, you won't do so well. And that's why a lot of the other side of the fence, people who argue for active management, the fund managers who argue for active management, let's be honest, the pessimist in me would say they would do, it's their job, and they get paid very handsomely for it. Question: who's paying for those flashy offices, money nerds? It's you, it's you as the shareholder. But anyway, often these fund managers they will try and argue that passive management means when markets are not doing so well, you're going down with them, you're not getting any value in times of market decline. But that's okay because markets decline a quarter of the time and they incline the remainder. So you accept that there will be the downturns, but in most cases there will be the upturns. And long-term buy and hold, the evidence tells us that these people who are taking a more backward seat with their investment journey do far, far better than those who are trying to be clever. If you haven't already, I would really encourage you to listen back to an episode I did a few weeks back, episode 144, with Fabrizio Zumbo from Vanguard. He said that your behavior is the problem when it comes to investing, and it's so true, is that we, you and I, are the most damaging risks to our financial plan. It's not investing in the first place. It's us trying to be the humans within us and trying to be clever, trying to over-engineer things, feeling restless with just remaining in our seats. We always want to be tampering. So active management scratches that itch far more than passive management. But passive management, it does everything and more for a lesser cost. Now, obviously, I'm not giving you regulated financial advice telling you what type of fund you should invest in within the passive space, but I can tell you, money nerds, that my own wealth strategy, the wealth strategy for my clients, relies heavily, heavily more on the passive management side. There are certain nuances fitting in in that spectrum that make it not as black and white as it might seem. But if you're doing this on your own, your own investment journey and you're faced with, you know, a fork in the road that says active versus passive, I highly encourage you to look at the data, look at what history has told us, and you will soon see that active management is really one of the the greatest greatest car crashes in financial planning and personal finance. It's a it's a sham that this can still exist. These firms are marketing machines, they're not financial freedom creators that they would allow you to believe you're paying handsomely for sub-performance. But going back to this episode, why is passive the wrong name for this? Because it can lead to people thinking, you know what, I'm not going to accept a second best route when it comes to my wealth, my family's financial fortress. Well, passive investing, although it doesn't sound very glamorous, it sounds pretty unsexy and second best. In reality, it's not. It is absolutely compelling. By definition, it is an active strategy. It's compelling and it's active because it focuses actively on what investors can control, which is your cost, your diversification, your discipline, and to a large extent your behaviour. You can't control the markets. That is the reality. So that's why passive investing, I would argue needs a better name, because that sounds pretty anticlimatic. And the way I frame this to clients in the portfolios that I use for myself, my own wealth journey, and those of my clients, is it's evidence-based investing. Because this is what the evidence, looking at the evidence, being as objective as we can be, where do market returns come from, what has always worked, and what would lead to the most probable good outcome for you as an end investor. And all of the evidence teaches us that going down the passive route leads to far more probable and favorable outcomes in contrast with the active route. But it's absolutely amazing that the active management industry continues to exist. And it's because they play on this emotion that you do not need to settle for mediocre. You do not need to be concentrated around the mean. They can be the outliers at the end that can deliver exceptional performance. Now, of course, active management can deliver exceptional performance, far more exceptional than passive, but it rarely does. And that's the key part, is it's highly unlikely that you're going to be one of the beneficiaries of that. If this fund manager, who is so certain about a place where they can add value in the markets because they think that Chinese equities are undervalued and there's an arbitrage pricing opportunity that they're going to absolutely capitalize on, they're so certain and they're such nice people that they're sharing that with you as their end investor. They're deciding not to invest their own personal money in that, but instead they're being an absolute diamond in sharing this with you. Are you getting my pessimism here, Money Nerds? And what makes the data even more compelling for index investing, or passive investing as we call it, too often than not, but let's reframe it as evidence-based investing. We're looking at what science and data has told us, and the evidence tells us that those few active managers that somehow do outperform the market, is it through skill or is it through luck? Because more often than not, the next year they colossally underperform. So if they're, you know, a broken watch is is right two times a day, or whatever the saying is, and the same applies to fund management, is sometimes someone will do well, someone will have made a good call that will play out favourably for their end investors. But can they do that repeatedly with certainty? I really would argue not. And this isn't me just on my soapbox. I'm going to link in the show notes to what's called SPIVA, SPI VA. And for over 20 years, Speva has effectively tracked the performance of active funds against their benchmarks worldwide. They tried to see, you know, would you end investor have been better going with an active approach or just tracking the market that the active manager is trying to outperform? And the results are sobering. If we look at broad brush measure of the United States market performance being the SP 500, the biggest 500 companies that are listed on the US stock exchange, then what we can see is if we were to look at how these funds have performed, active funds have performed in comparison with the SP 500, we can see that over one year 78.78% of funds underperformed the SP. So broadly speaking, four out of five underperformed the general market. One out of five outperformed. So you might say that's pretty good odds, but would you take that bet with your family's financial fortress? I certainly would not. When we extend it to three years, the data actually goes more in favour of active management. Broadly speaking, a third of funds, active managed funds, outperform the general market. But what happens if we extend it to five years? We're now starting to get out of the realm of chance here, and just 11% of funds outperform the general market. If we extend it to ten years, we're talking about 14%, and over 15 years, which is arguably the best data we have right now, we can see that 10.07% of funds have actively outperformed the SP 500. So one in 10 will outperform, and the vast majority, 9 of 10, will underperform. That is bonkers in my mind that fund management and active fund management still profess that they add value to clients because more often than not they don't, and the analysis and the evidence does not lie. So I want to encourage you, money nerds, in this slightly shorter episode of Heads Up on Money, and for some reason this is the topic I've chosen for our 150th episode special. But I really want to encourage you that when you hear the phrase passive investing or index investing, that can bring up bad connotations because we think we're settling for second best, and you're very much getting the short end of the stick. But the reality and the evidence tells us that couldn't be further from the truth. Index investing, passive investing, let's bin these names and reframe it as evidence-based investing. Looking at what evidence has told us, which is all we can ever rely upon when it comes to investing in the absolute, immeasurable, volatile, human-driven intricacy that is the stock market. We can never apply that much logic to this because we're dealing with people and people are irrational. But over long periods of time, when we look at the evidence, it tells us compellingly that active management does not work. So I really encourage you if you take one thing from today, is reframe how you're thinking about the index active debate. Indexing, passive investing is not second best. And keep in mind that all of these funds that are underperforming, they're not just underperforming Apples versus Apples, they're underperforming, and also there's a drag because you're paying higher fund management fees for that underperformance. That's the crazy thing. So review the funds that you're invested in within your portfolios. If you're paying one and a half percent to a fund manager, are you actually getting value from them to offset those exorbitant charges? Charges is one of the only knowns you have in your financial plan. So take good ownership of it, take care of what you're paying, make sure you're getting value for the charges you are paying because if you're not, it's going to inhibit the growth potential in your portfolio. And at the end of the day, when all is said and done, all that's going to do is potentially hamper your ability to send your kids to university, to retire when you're 55, to step back from work at 50 and go part-time, to buy yourself independence and freedom in the future, which is what the end goal should be for every financial plan. Regardless of how that independence or freedom looks to you, that'll be personal to you in your financial plan, but we're all fighting towards the same cause, and looking at the data, active investing is a roadblock in that plan. So I hope you have taken from today what I hope you would get from it in that passive is not a bad thing. If anything, passive is an active decision. It's an active decision to apply logic and science as much as we can when it comes to investing to our investment journey. So there we go. Episode 150 draws to a close. Hopefully, it's a bit shorter one than a couple of the episodes I've done recently, which have been a bit technical in nature. Thought I'd get back to the wonderful world of investment management in this one. If you have any questions, Money Nerds, you know where to find me. The links to my contact details is in the show notes. Otherwise, I hope you have a wonderful weekend. Enjoy the rest of your personal finance Friday or whenever you're listening to this. I'll see you next week when we rolls around for another episode. Until then, stay safe out there. Goodbye for now.