The Power of Passive Investing: More Wealth with Less Work

Contents

Foreword

Preface

Acknowledgments

Part I: The Active Versus Passive Debate

Chapter 1: Framing the Debate

In the Beginning, There Were Active Funds

Passive Investing Makes Its Case

All about Indexes and Benchmarks

The Portfolio Management Debate

Summary

Chapter 2: Early Performance Studies

Cowles Commission Report

The Quiet Period

The Rise of Mutual Funds

The Roaring 60s

Summary

Chapter 3: The Birth of Index Funds

The First Indexed Portfolios

The First Index Fund

Summary

Chapter 4: Advances in Fund Analysis

The Early Years in Review

Building on Success

The Three Factor Model

Three-Factor Analysis for Everyone

Four-Factor Models and Beyond

Does Anyone have Skill?

Summary

Chapter 5: Passive Choices Expand

The Growth of Indexing

The First Fixed Income Index Fund

International Equity Index Funds

Real Estate Investment Trusts

U.S. Small Cap

Revisiting SPIVA Performance Studies

Active Management Invades Indexing

Summary

Chapter 6: Portfolios of Mutual Funds

Efficient Portfolios

Portfolio Choices

The Bottom Line Is Your Bottom Line

Summary

Part II: Chasing Alpha and Changing Behavior

Chapter 7: The Futility of Seeking Alpha

All That’s Needed Is a Crystal Ball

Past Performance as a Way to Predict Future Returns

Fund Expenses as a Predictor of Top Performance

Ratings as a Predictor of Top Performance

Qualitative Factors as a Predictor of Top performance

Summary

Chapter 8: Active and Passive Asset Allocation

Tactical Versus Strategic

Mutual Fund Flows Show Bad Timing

Measuring the Timing Gap

Dumb Money versus Smart Money

Putting It All Together

Summary

Chapter 9: Changing Investor Behavior

Helping People Go Passive

Three Non-Indexers

Investing Is Serious Business

Summary

Part III: The Case for Passive Investing

Chapter 10: The Passive Management Process

The Five Step Process

Investment Policy Statements

Summary

Chapter 11: The Passive Case for Individual Investors

Begin at the End

Estimating Future Obligations

The Asset Side

Matching Assets to Obligations

Asset Allocation

Risk!

Investment Decisions

Hired Help

Summary

Chapter 12: The Passive Case for Charities and Personal Trusts

Your Role as a Trustee

Laws Governing Trusts

Trusts and Passive Investing

Private Trust Management

Nonprofit Organizations

Passive Versus Active Investing

Watch Out For Conflicts of Interest

Summary

Chapter 13: The Passive Case for Pension Funds

Legal Acts Governing Pensions

The Plight of the Small Plan

Self-Directed Retirement Plans

Summary

Chapter 14: The Passive Case for Advisors

More Risk Means More Fees

Types of Advisors

The Role of the Fiduciary Advisor

What Clients Expect from Advisors

What Advisors Present

Summary

Glossary

Notes

About the Author

Index

Additional Praise for The Power of Passive Investing

"The retail stockbroker will soon become as extinct as the dinosaur, and good riddance. Thousands of investment professionals, tired of selling the same old lies, and millions of their clients, tired of hearing them, have deserted the brokerage business for a more elegant, effective, and honest way of managing money. Twenty years ago, Rick Ferri helped pioneer that transition. If you’re an advisor or a broker, you owe it to yourself to read The Power of Passive Investing; if you’re an investor, you owe it to your pocketbook."

—Bill Bernstein, author, The Investor’s Manifesto

"I’m a big fan of Rick’s books, and this is his best yet. It’s the book on how to effectively harness the power of passive investing. Whether you are an individual investor or are responsible for billion-dollar portfolios, this book is critical to your success."

—Allan Roth, author, How a Second Grader Beats Wall Street

Rick Ferri has written yet another terrific book. The numerous studies he reviews provide powerful support for passive investing and guide trustees and other fiduciaries toward this ideal solution.

—W. Scott Simon, principal, Prudent Investor Advisors, LLC

"Passive investments deserve a place in almost all investors’ portfolios, but the range of choices has never been so complex or treacherous. There are now every bit as many flawed, gimmicky, or overpriced index funds as there are those from active managers. If you want to navigate this new terrain successfully, you’ll find Rick Ferri’s The Power of Passive Investing an essential text."

—Don Phillips, Managing Director, Morningstar, Inc.

Powerful! The extensive research behind this book makes a compelling case for a passive investing strategy. Ignore the information in this book at your own peril.

—Mel Lindauer, Forbes columnist and co-author of The Bogleheads’ Guide to Investing and The Bogleheads’ Guide to Retirement Planning

"The Power of Passive Investing is as much an enlightening history lesson as a compelling argument for building a portfolio on a foundation of index funds. Rick Ferri invigorates a long-standing debate with fresh proof and perspective that come from managing millions of dollars and reading reams of research. Don’t mistake passive for wishy-washy; Ferri’s arguments are as sound, precise, and forceful as you’d expect from a retired Marine Corps fighter pilot."

—Robert Brokamp, CFP, Senior Advisor, The Motley Fool’s Rule Your Retirement service

If you doubt the power of passive investing, check out Rick Ferri’s new book—and you’ll discover a wealth of evidence that should sway even the most ardent fan of active investing.

—Jonathan Clements, author, The Little Book of Main Street Money

Rick Ferri convincingly lays out the damage done by investing in actively managed mutual funds. He proves why we should be grateful to Jack Bogle for implementing index funds as a shield against Madoff-type shysters, lawsuits, unnecessary risk, and high costs. His clear writing, serious research, sound logic, and nuggets of wisdom illuminate both old and new-to-me dimensions of the compelling case for indexing.

—Ed Tower, Professor of Economics at Duke University

Old-school index investing seems so simple, it’s amazing that someone like Rick Ferri, who just tells us the truth, is so rare. And what is the truth? That most investors are underperforming the market and being fleeced by Wall Street. We’re lucky to have a crusader for common sense like Rick on our side.

—Jim Wiandt, President and CEO, IndexUniverse

"Few people understand indexing better than Rick Ferri. In The Power of Passive Investing, Rick clearly explains the sophistication of passive investing and how it will enhance account performance. If you haven’t yet incorporated passive investing into your portfolio, this book will convince you."

—Taylor Larimore, co-author of The Bogleheads’ Guide to Investing and The Bogleheads’ Guide to Retirement Planning

"Rick Ferri has brilliantly assembled hordes of unbiased, highly technical investment research so that the average investor can understand and benefit from what the smart money has known for decades. If you care about how much you’ll retire with, you’ll read The Power of Passive Investing."

—Mitch Tuchman, CEO, MarketRiders, Inc.

Rick Ferri has gathered a wealth of research. A passive investment strategy is a great approach because it allows a person to focus on more important things in life.

—Craig Israelsen, author of 7 Twelve: A Diversified Investment Portfolio with a Plan

I found this book to be an outstanding resource for the passive investor as well as those who could benefit from this approach. It’s another most excellent contribution by Rick Ferri.

—Sheryl Garrett, CFP, AIF, Founder, Garrett Planning Network

This book is an enormous gem of a history lesson on a profoundly sophisticated (and simple) strategy that has changed the world of investing forever. Rick Ferri’s work is a must read for everyone who accepts responsibility for their own financial well-being, giving readers the authority to turn away from Wall Street and make intelligent investment decisions on their own.

—Bill Schultheis, advisor and author, The New Coffeehouse Investor

Enemies of passive investing aren’t going to like this book, but who cares what they think? Ferri provides more damning evidence against stock picking and other money-losing strategies that bomb investors’ portfolios. In the end, passive investors win.

—Ron DeLegge, host, The Index Fund Investing Show

Having originally been trained in the hedge fund space to think actively, I know there is a large group of investors with an ‘active management’ state of mind. However, given what I know of many retail investors and a surprising number of institutional investors, I can’t help but think that for their own benefit, the passive-oriented approach espoused by Rick in this book is a likely path to minimizing future regret.

—Richard C. Kang, Chief Investment Officer and Director of Research, Emerging Global Advisors, LLC

‘Odds are you’ll earn well below market returns in your portfolio over your lifetime if you believe that the mutual funds you’re choosing or your advisor selects will beat the markets.’ Strong words, but in this eminently readable book, Rick Ferri makes a more than compelling case in favor of passive investing. Wouldn’t you like your portfolio to be managed by nothing but managers who shoot par? If you’re a professional or a retail investor, following the lessons introduced in this book will unquestionably improve your bottom line.

—Harold Evensky, President, Evensky & Katz

In this well-crafted book, the author ponders the question of why pay high fees to active managers when index funds—those that follow a real market benchmark, not just a disguised active investment strategy—can do better on a risk-adjusted basis? A strong case is built for passive investing, with arguments backed with market facts and a thorough review of decades of unbiased academic and practitioner studies. At the same time, Rick reminds us of the power of strategic allocation over tactical allocation in meeting a client’s long-term financial goals. This book is a valuable resource, and I highly recommend it.

—Seddik Meziani, PhD, Professor of Finance and Economics, Montclair State University

"By focusing on the irrefutable facts, Rick Ferri has put together an unassailable case for The Power of Passive Investing. Advisers who implement the principles outlined within this book will strengthen their relationships with clients by delivering solutions in lieu of products."

—Rudy Aguilera, Principal, Helios LLC

The Power of Passive Investing

Books by Richard A. Ferri

The ETF Book

All About Asset Allocation

All About Index Funds

The Bogleheads’ Guide to Retirement Planning (with Mel Lindauer, Laura Dogu, and Taylor Larimore)

Protecting Your Wealth in Good Times and Bad

Serious Money: Straight Talk about Investing for Retirement

Copyright © 2011 by Richard A. Ferri. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

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Library of Congress Cataloging-in-Publication Data:

Ferri, Richard A.

The power of passive investing: more wealth with less work / Richard A. Ferri.

p. cm.

Includes index.

ISBN 978-0-470-59220-5 (hardback); ISBN 978-0-470-93708-2 (ebk);

ISBN 978-0-470-93712-9 (ebk); ISBN 978-1-118-00390-9 (ebk)

1. Index mutual funds. 2. Investments. I. Title.

HG4530.F428 2010

332.63'27—dc22

2010028567

Foreword

In The Power of Passive Investing, Rick Ferri has given us a comprehensive guide to what is proving to be a virtual revolution in investment strategy. Up until the 1980s, stock picking was the dominant method of investing by individual investors. Then, through the 1990s, professional investment supervision through actively managed mutual funds was ascendant. But, gradually, index investing—buying and holding a portfolio representing the entire stock (or bond) market, or various sectors of those markets—has attracted the most attention (and dollars) from investors.

Rick’s book begins with the historical background of index funds. As one who was present at the creation of the first index mutual fund in December 1975, I can attest to the accuracy of his chronology. (My first decision at the upstart firm Vanguard, which I founded and which began operations in May 1975, was to form the world’s first index mutual fund.) We also learn about the other pioneers of the concept of indexing, including Treynor, Samuelson, Malkiel, Ellis, and Sharpe.

The simple fact is that indexing wins because indexing must win. After all, we investors as a group are destined to be average. (In a stock market with a 7 percent gross annual return, we all divide up that 7 percent.) But after we account for the costs of investing—what I call the croupier costs, an estimated 2½ percent—we (again, as a group) earn a net return of 4½ percent. The best index funds win simply because they eliminate management fees and sales loads, and minimize operating costs and portfolio turnover and its costs. In so doing, they provide their services at an annual cost of as little as 1/10th of 1 percent of assets. It is the relentless rules of humble arithmetic that drive the theory of passive investing.

But Ferri takes us from theory to reality, providing scores of examples and tabulations that prove that very point. Like many analysts, he finds that it is not past fund performance but low costs that are the best predictor of future (relative) fund returns. In one particularly striking exhibit, he shows that an investor holding a portfolio of five equally-weighted mutual funds has but a 3 percent probability of beating the stock market index over 25 years. (For a holder of 10 funds, the probability is only 1 percent). Again, the historical record confirms the hypothesis.

The Power of Passive Investing also deals soundly with such broad areas as savings and investment, asset allocation, and the use of financial advisers. That is Rick’s profession, and he is an outspoken advocate for the indexing approach. By charging minimal fees for his services, he walks the walk that reflects the talk he talks in this fine book. I commend it to you.

John C. Bogle

Valley Forge, PA

September, 2010

Preface

Did you ever buy something because you thought it was a superior product, only to be disappointed with the results? That’s the problem with most mutual funds. They don’t deliver on their promise.

Investors buy mutual funds in most cases because they believe the fund manager will earn superior returns over a market average. But that’s not what typically happens. Most funds that try to beat the market underperform the market, some by a wide amount. Investor hope fades quickly as the reality of mediocre results roll in. Then they search for new funds, finding new hope, and fail again. This vicious cycle has been happening in the mutual fund industry for almost a century.

Odds are you’ll earn well below market returns in your portfolio over your lifetime if you believe that the mutual funds you’re choosing or your advisor selects will beat the markets. That’s not going to happen, at least not in the long term. Perhaps one or two funds will achieve this difficult goal if they survive long enough, but a portfolio of several funds will not beat the markets in aggregate over time. That’s almost a certainty.

The advertising from fund companies will always imply that their managers have delivered superior returns and that you can capitalize on this skill and earn superior returns in the future. That’s wishful thinking. As a group, mutual fund managers have no special talents and outperformance is more a matter of luck than skill. The academics have been saying this for decades.

There is an alternative. The failure of active fund managers to deliver on their promise of high returns while continuing to charge high fees creates a compelling case for passive investing. Passive investing is all about investing in low-cost passively managed index funds and exchange-traded funds (ETFs) that match the financial market returns less a tiny fee for expenses. This strategy lands your portfolio much closer to the market’s return than active fund management, and it ensures that you’ll earn your fair share of those returns.

Your goal as an investor is to earn the highest return feasible given the specific amount of risk chosen for a portfolio. A passively managed portfolio holding index funds and ETFs will outperform an overwhelming majority of portfolios using actively managed mutual funds that try to beat the markets with the same amount of risk. Said another way, a passive portfolio will greatly increase the probability you’ll reach your financial goals.

This book provides you with the detailed studies and undeniable evidence favoring a passive investing approach. It’s filled with academic research and data that goes back many decades. This information clearly shows that trying to beat the market has never been a reliable investment strategy in the past, and there’s no reason to believe it will beat a passive approach in the future. Passive investing increases the probability that your portfolio and the portfolios you may oversee for others will succeed. Passive investing IS power investing!

Possible but Not Probable

Wall Street is full of promises. Companies that actively manage mutual funds promote their products based on the perception that they’re staffed by very smart and informed people and that they’ll earn higher returns than the markets. What investors don’t see, and most don’t consider, is the academic facts proving that most funds don’t achieve this goal. There’s only a low probability that any fund will achieve superior returns. While it’s possible, it’s not probable.

A sign on the highway promoting the Powerball lottery only displays the possible amount you could win; it doesn’t tell you the low probability of winning. Most investment opportunities are sold the same way. Wall Street promotes the possibility of earning superior returns—not the probability.

Low odds for selecting a winning mutual fund isn’t the only problem for investors. A second problem is payout. The few active funds that are winners don’t pay enough excess return over the market’s return to make up for the selection risk. There are a large number of losing active funds, and many of those losing funds fall far short of the market’s return. The few winning active funds don’t perform well enough to make up for the poor results of the large number of losing funds.

A third problem for active mutual fund investors is the shortfall created when multiple funds go into a portfolio. A portfolio of several actively managed funds has lower odds of success than each fund independently. As more actively managed mutual funds are added to a portfolio, the outperformance rate for the total portfolio drops dramatically. This problem compounds over time, and after enough time, the probability for outperforming a passive approach drops to near 0 percent.

Winning actively managed funds are only a small percentage of the total funds outstanding, and identifying these winning active funds in advance is nearly impossible. There are no proven methodologies that accurately predict future winning active funds. Of course, that doesn’t stop many market gurus who will claim to have a winning active fund picking formula that they’ll sell you for a fee. But that’s just marketing spin meant to separate investors from their money.

Attempting to earn above market returns by picking actively managed mutual funds is an inefficient use of time and money. Knowing this fact, and acknowledging it allows you the freedom to go in a different direction—to change religion in a sense.

Passive versus Active Investing

The Power of Passive Investing lays out an irrefutable case for buying low-cost passively managed index funds and ETFs. It amplifies an investment philosophy that’s been academically proven over the decades to deliver better returns than beat-the-market fund strategies. With the power of passive, you can build a more profitable portfolio that meets your needs and the needs of the people whose money you oversee.

Passive investing is based on the premise that all financial market participants in the aggregate are better at determining securities prices than an individual who disagrees with those prices and attempts to predict price direction and earn excess profits. It has to be this way. For every buyer of securities there must be a seller. The return of the market is the only return available to investors, and it’s shared by all investors. If one person earns a higher return it means someone else missed out. There is no other return.

But there’s a problem: Investors don’t earn the market return in aggregate. Money management doesn’t come free. Take out a few hundred billion dollars per year in expenses to trade securities and manage investments, and you can easily understand why it isn’t possible for investors to outperform the markets over the long term. The average investor must underperform the markets given the costs of investing.

You wouldn’t know this by reading advertisements from mutual funds; brokerage firms; money management companies; advisors; or what’s written in most books, magazines, investment newsletters, and web sites. They make it seem as though everyone is winning. That’s simply not true and can’t be true.

The Power of Passive Investing makes the case for creating a sound long-term investment policy using low-cost index funds and ETFs that gets you closer to the natural returns of the markets. It’s also about clarifying and quantifying the purpose for investing, and then implementing a prudent plan that has the best chance for meeting this goal within a framework of controlled risk.

Mutual Funds are a Great Idea

Mutual funds are a great investment vehicle. They allow investors to participate in the global financial markets at a relatively low cost by pooling assets together with other investors to gain economy of scale. In addition, fund shareholders have daily liquidity. They can purchase or redeem fund shares any day the market is open.

The modern mutual fund industry had its start in Boston in 1924. Despite its meager beginnings, the industry survived the Crash of 1929 and the Great Depression that followed. Today, there are over 7,000 different distinct mutual funds including about 1,000 exchange-traded funds offered by hundreds of mutual fund companies.

It wasn’t until 1976 that the first publicly available index fund was launched by the Vanguard Group. The concept was slow to catch on. However, it didn’t take long for investors to realize the value that indexing offered. Today, there are hundreds of index funds tracking practically every asset class, investment category, and style.

Exchange-traded funds had their beginning in late 1993. Most of these products are also designed to track indices. Exchange-traded funds are a type of mutual fund. The main difference between a traditional open-end mutual fund and an ETF is that the ETF shares trade continuously during the day on an exchange rather than at the end of the day with a fund company, as traditional mutual funds do.

Between open-end index funds and exchange-traded products, anyone can create an all-passive portfolio using products that are low cost, tax efficient, and hassle free. Investors who prudently select and maintain a portfolio of low-cost index funds and ETFs will earn higher returns with less risk than those who cling to actively managed funds. It’s just a matter of time.

Passive investing with index funds and ETFs works. However, you won’t find many passive portfolios in this book. This book makes the case for passive investing. You’ll have to read other books for details on asset allocation recommendations and fund selection methods. Several books are highlighted within these chapters.

Index Funds Make Most Active Funds Obsolete

It wasn’t necessary for actively managed mutual funds to beat the market prior to the introduction of index funds because they were the only game in town. They were the only option available. Mutual fund companies fulfilled their obligation to investors by offering a broadly diversified portfolio of securities that individuals could not replicate on their own at the same cost. In this regard, actively managed funds were a good deal for investors. But that era has passed.

Today, actively managed funds aren’t needed to gain broad diversification in an asset class. Index funds and ETFs perform that function much more efficiently. The costs are lower, diversification is broader, the transparency of fund holdings is superior, and the tax benefit from lower turnover helps investors whose accounts are subject to taxation.

The growth of index funds and ETFs across the spectrum of asset classes has put actively managed fund companies on the defensive. Since the actively managed funds are no longer the most efficient way to gain broad diversification at low cost, the active fund industry has had to fashion another reason for being. This new reason for being is to beat the market.

In a sense, index investing has forced active managers into their difficult beat-the-market mission. After Vanguard introduced index funds in 1976, the active fund industry reacted with some interesting comments. The head of the largest active fund company at the time asked investors why anyone would want just average returns. Another called it Bogle’s Folly after Vanguard founder John C. Bogle. Still another fund company went as far as printing a poster that labeled index funds as un-American.¹

Active funds were no longer the most efficient way to invest in the markets after the introduction