Passive Strategies

The Battle Of The Passive Strategies

My first book, The Only Guide to a Winning Investment Strategy You’ll Ever Need, was first published 20 years ago, in May 1998. With its 20th anniversary in mind, let’s see how my recommendations worked out for investors who followed them.

Get The Timeless Reading eBook in PDF

Get the entire 10-part series on Timeless Reading in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

We respect your email privacy

Q1 hedge fund letters, conference, scoops etc, Also read Lear Capital: Financial Products You Should Avoid?

The book had two main themes. The first was that, while markets were not perfectly efficient, they were sufficiently efficient to make active management a loser’s game. While the game was possible to win, the odds of doing so were so low that, even before taxes, it was not prudent to try. That led to my recommendation to avoid actively managed funds. Instead, I suggested investors use passively managed funds, such as index funds and other structured portfolios, that eschew both individual security selection and market timing.

If the battle between active and passive strategies were a prizefight, the judges would have long ago declared a TKO. Year after year, the S&P Dow Jones Indices SPIVA scorecards show that, no matter the asset class, the majority of actively managed stock and bond funds underperform their benchmark indices – and the longer the investment horizon, the greater the failure rate. That’s even before considering taxes, which are often actively managed funds’ largest expense. Several recent studies, including Eugene Fama and Kenneth French’s "Luck Versus Skill in the Cross-Section of Mutual Fund Returns," have found similar results; today, only about 2% of actively managed funds are generating statistically significant alpha. That’s down from about 20% 20 years ago. Again, that’s before taxes.

Using passive strategies was clearly the winning strategy and, thus, was the right recommendation.

The second theme was based on research, specifically, Fama and French’s “The Cross-Section of Expected Stock Returns,” showing that, in addition to market beta, equities had two other unique sources of risk and expected return: size and value. Not only did small and value stocks have higher expected returns, but, as unique sources of risk that added incremental explanatory power to the cross-section of equity returns, they also provided diversification benefits. Thus, my recommendation was for investors to consider “tilting” (that is, having more than the market’s exposure) their portfolios to small and value stocks both domestically and internationally. This was a very different strategy than the total stock market approach recommended by John Bogle (the father of index investing). Thus, this dichotomy is the “battle of passive strategies.”

The following table shows the results investors could have earned using both strategies. The data covers the 20-year period from May 1998 through April 2018. It shows the annualized returns, volatility and Sharpe ratio for Vanguard’s three total market funds (U.S., international and emerging markets) and the structured asset class portfolios from Dimensional Fund Advisors (Dimensional). (Full disclosure: My firm, Buckingham Strategic Wealth, recommends DFA funds in constructing client portfolios.)

The data is based on the returns of live funds, not back-tested index (paper) portfolios. Thus, it includes not only the fund’s expense ratio, but also all implementation costs. Despite the higher expense ratios and higher turnover, in each case Dimensional’s small and value funds not only provided higher returns than Vanguard’s lower-expense total-market funds, but they also provided higher Sharpe ratios (a measure of risk-adjusted returns).

In the U.S., the outperformance ranged from 1.2% per year for large value to as much as 2.6% for small value. In developed markets, the outperformance ranged from at least 1.6% per year for large value to as much as 3.4% for small value. Finally, in emerging markets, the outperformance ranged from 3.4% per year for large value to 4.1% for small stocks and 5.0% for small value. Despite the higher volatility associated with these riskier assets, in each case Dimensional’s funds earned higher Sharpe ratios. While investors should have expected the higher returns, they shouldn’t have expected the higher Sharpe ratios; if you believe markets are efficient, then you should also believe all risky assets ought to provide similar Sharpe ratios.

Passive Strategies

Read the full article here by Larry Swedroe, Advisor Perspectives

Print Friendly, PDF & Email


Subscribe to our mailing list

* indicates required

Opt out of occasional 3rd party offers

Congrats! We have a limited time offer for loyal readers like yourself.

Sign up today and get three months free if you select yearly subscription

Use coupon code 3monthsfreeconfidential at checkout

Limited time offer only expires 3/31/2019 or next 30 subscribers whichever comes first – please do not share this discount with others