Can’t I or my advisor just pick the best active fund managers?
There is no reliable way to do this. Studies show that past performance is no indication of future success. With so many funds out there, inevitably some will outperform the market, perhaps by a large margin, and perhaps for an extended period of time. But it is impossible to separate skill from chance. Some managers may have true skill, but it is still difficult for them to overcome the fees they charge. Winning funds also become less agile as they balloon with cash. There may be another Warren Buffet of our generation, but we will never know it in advance.
What if I don’t have enough to start investing with an advisor?
With less than $100,000 it is difficult to find a hands on advisor. In order to start out, many clients might find it worthwhile to pay an advisor an hourly fee to help them set up a plan they can administer on their own. Companies such as Vanguard offer extremely simple solutions for individual investors that include low-cost index funds.
What if I’m rich and I can afford to invest with exclusive hedge funds?
Hedge funds are allowed to use alternative investing strategies that can often incorporate more risk. As such, the returns they post can often be jaw-dropping- both positive and negative. Even sophisticated hedge funds find it difficult to beat the market over the long term. What is more, the fees they charge are often very excessive, and overcoming those fees to provide value to their clients is a long-shot. You may notice that hedge fund managers and their clients are all very rich. Keep in mind that the clients were rich in the first place, and the managers are rich because they prevent substantial amounts of money from ending up in their clients’ pockets, where it belongs.
My financial advisor keeps showing me how he beats the indexes.
Unless your financial advisor is very lucky, he is not telling you the whole story. He may not be showing you results from a long term timeframe. He also may not be comparing apples to apples. If your advisor is showing you a fund that invests in many small-cap stocks, for instance, and compares it to the S+P 500, which is made up of large-cap stocks, he is making a meaningless comparison. He should be benchmarking that fund against a small-cap index. If your advisor can show you that his actual portfolios have actually had better returns than a very similar portfolio of index funds over a long period of time, than you have a truly gifted advisor. But that is probably not the case.
Don’t index funds only provide average returns?
Index funds provide average market returns. Unfortunately, most investors do not even achieve this level of performance. As an index investor you will be outperforming almost everybody else over the long term.
Don’t you get what you pay for?
No. In the competitive world of finance, almost nobody can consistently beat the indexes. So, as Vanguard founder John Bogle has stated, you get what you don’t pay for. Lower fees are the ticket to higher returns.
Is passive investing a good idea in a taxable portfolio?
Yes. Passive funds typically have much lower turnover, and therefore lower taxable distributions each year. Taxes can be a serious drag on investment performance, and passive management is much more tax-efficient than active management.
If passive management is so great, why doesn’t everybody do it?
In 1975 John Bogle, the founder of Vanguard, started the first index fund for individual investors. Since then index fund investing has steadily grown in popularity. In fact, Bogle’s original index fund, now labeled the Vanguard 500 Index Fund, which tracks the S&P 500, is the largest mutual fund in the world. Vanguard is also the largest no-load mutual fund company in the world. Along with Vanguard, a number of other companies have continued to roll out new index-based mutual funds and exchange-traded funds. Index investing grows more available and popular by the day.
However, despite the fact that a number of companies have built successful businesses on index funds, it is no surprise that there is pushback from the financial industry. Switching to a business model that requires less staff, provides less profit, and gives more value to the investor is not an easy transition. If fund managers and advisors were more honest with themselves about the reality of index investing, and more honest with their clients, it seems certain that index investing would have grown even more popular than it is today. Either way, passive management has facts and probability on its side, and it should continue to grow.