Don’t confuse Passive Investing returns with average returns.

“I can’t believe that the great mass of investors are going to be satisfied with just receiving average returns” –Edward C. Johnson, Fidelity Chairman, when asked about passive investing.

Unfortunately Mr. Johnson’s comment echoes the sentiments of the typical broker or financial advisor. They believe that because passive investing accepts market rates of returns, they produce average rates of return. In a minute, we’ll see why nothing could be further from the truth. But first, let’s examine why this message is being spread to investors.

To truly understand the industry mentality, we need to realize how mutual fund firms, brokerage houses, and financial advisors make their money. The entire premise of the brokerage industry is that brokers add value by being able to pick stocks or forecasting the future direction of the market. In fact, they spend millions each year in advertising to convince you that they have this skill. However, one needs to look no further than the firms themselves to shatter that myth. If they could time the market or pick stocks, it would be difficult to explain why millions of investors lost trillions of dollars during the tech bubble and even more during the downturn of 2008.  When asked about indexing, the typical broker’s response is,”Indcxing is for investors who want average returns. You want to do better than average, don’t you?”

Here’s the truth. A simple unmanaged index fund consistently beats the majority of active mutual fund managers year after year. There are those lucky managers to do beat the indexes at times but their future success in doing so is a crapshoot. The rub is, you cannot rely on past performance of managers to predict their future performance (there are numerous studies about it)–and that’s why I call them ‘lucky’.

Remember the performance of mutual funds during 2000-2009, often mislabeled the “Lost Decade”? Most actively managed funds were lucky to eek out a positive return. Our globally diversified, all-equity portfolio returned over 70%. I’m not trying to brag because those returns weren’t due to some genius stock picking or crafty market timing. I’m just trying to point out that you don’t need to engage in destructive behavior like stock picking and market timing (i.e. active management) to get positive returns.

Bottom line is that passive investing produces market returns, not average returns–which are far lower–and it does so in a low-cost and relatively tax-efficient manner. The average active mutual fund produces below market results (maybe you could even call them ‘average’ returns?) and does so with great consistency and in a tax-INefficent manner.

So to respond to Mr. Johnson of Fidelity, I would say, “You are correct, sir. My clients and I won’t be satisfied with average returns–which is exactly why I don’t invest in your funds and I invest passively.”

Keep the faith,

John Choi

 

 

 

 

 

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