Passive index investing v. Low Cost Active Investing

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Wasatcher
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Passive index investing v. Low Cost Active Investing

Post by Wasatcher »

With apologies for belaboring a basic tenant of bogledom. . .

I get the theory behind passive investing in broad index funds and how such an approach will outperform over time active investing due (in large part) to higher fees. So are there any rigorous studies that demonstrate the theory holds true even if one limits the comparison only to low-cost active investing. For example, let's say I restrict my selection to active funds with ER of less than [.75%], thereby getting rid of all the high-cost funds that have such a drag on the overall averages. Do my index ponies still win on this tilted race track? Is the problem that I would still have to select from among hundreds of low-cost active funds and might choose a corral of nags?
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mhc
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Re: Passive index investing v. Low Cost Active Investing

Post by mhc »

The other thing you would have to look at for the active fund is the potentially higher tax drag. Since the active fund manager has to do something, he will usually have an higher turnover rate, which increases the tax drag. Passive index funds have low turnover.
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SimpleGift
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Re: Passive index investing v. Low Cost Active Investing

Post by SimpleGift »

Even if you restricted your choices to low-cost active funds, these would still have significant trading costs due to their buying and selling of stocks throughout the year. Most studies I've seen estimate that the annual trading costs of active funds are comparable in magnitude (or even greater) than their expense ratios — depending on their annual turnover rate:

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Wagnerjb
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Re: Passive index investing v. Low Cost Active Investing

Post by Wagnerjb »

jahol000 wrote:So are there any rigorous studies that demonstrate the theory holds true even if one limits the comparison only to low-cost active investing.

None that are rigorous. A few years ago there were two studies done by students at Duke (search for Ed Tower in Google and you will probably find them) that studied the performance of Vanguard active funds against Vanguard passive funds. This certainly provided a study of performance that was limited to low-cost active funds. But the methodology was weak, as they only compared the Vanguard active fund to the nearest Vanguard passive fund. They generally found that the active funds tied or slightly exceeded the performance of the passive funds.

When you look at the study in a bit more depth you notice that the outperformers were dominated by two or three funds that didn't have passive counterparts. The one I remember most is the Vanguard International Explorer fund, which holds int'l small caps. They compared this fund to Vanguard's Total International Fund (at the time it was 100% large caps), and not surprisingly they concluded that the International Explorer fund had tremendous outperformance. When you take away the active funds that don't have an appropriate Vanguard passive fund, the active portfolio underperformed.

The problem with that kind of analysis (Vanguard vs. Vanguard) is that it makes incorrect comparisons and doesn't reflect what investors actually do. As an example, if I wanted to benchmark the performance of Vanguard's International small cap fund, I would compare the performance against an iShares ETF or maybe a WisdomTree ETF. These are the low-cost passive funds that investors here use, and they would be better benchmarks.

Bottom line - we don't have any rigorous studies. My gut feel is that a truly well-done study would show low-cost active funds as very competitive with low-cost passive funds, but still slightly underperforming.

Best wishes.
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Rick Ferri
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Re: Passive index investing v. Low Cost Active Investing

Post by Rick Ferri »

My analysis shows that low-cost active investing may get a fund closer to an index fund return, but the probability it will beat an index fund equivalent is no higher than funds with average fees.

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heyyou
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Re: Passive index investing v. Low Cost Active Investing

Post by heyyou »

There are always a few better-than-the-index actively managed funds, but there is no consistency of which ones they are. No one has yet figured out how to choose any of them prior to their outperformance.

The analogy is how a few of all of the active rabbits race well for a couple of years before fading to below average, while every index tortise continues to slowly but effectively plod onward, delivering average returns for several decades.
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Wasatcher
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Re: Passive index investing v. Low Cost Active Investing

Post by Wasatcher »

Thanks all for your responses and conclusions which are as I suspected. Looks like I can stick with my passive index strategy and worry about more important things in life. Regards.
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