Passive vs. Active Investment Approach

Active Management – Flaws of Market Timing and Stock Selection

Flaws of Market Timing

Active management is the art of stock picking and market timing. Active investment managers attempt to "time the market" by actively buying and selling those stocks that they believe to be mispriced so as to capitalize on subsequent price corrections in the market. The success of this strategy depends on the active manager's ability to predict market events.
The Efficient Market Hypothesis states that markets quickly and accurately reflect available information and are setting "fair" prices for the buyer and seller. Given this information, it would be very unlikely that an active manager could find a mispriced stock. The fallacy of market timing can be demonstrated by removing the effects of the best days in the market as shown below:

1991 - 1998	Returns*
2,023 Trading Days	19.87%
Minus 10 Best Days	13.63%
Minus 20 Best Days	9.21%
Minus 30 Best Days	5.35%
Minus 40 Best Days	1.90%

Source: John D. Stowe, A Market Timing Myth. Journal of Investing, Winter 2000. Performance is historical and does not guarantee future results. Information from sources deemed reliable, but its accuracy cannot be guaranteed.

*CRSP value-weighted index with dividends reinvested. Compound annual returns assume a 1% transaction cost per portfolio turnover.

Flaws of Stock Selection

It is best to demonstrate the inability to pick a winning stock combination by showing the following data from the Bogle Financial Center and Lipper, Inc., who studied the performance of 851 US equity mutual funds for two consecutive four-year periods.

Rankings of Top Ten Funds in one Four-year Period, Compared to Rankings in Next Four-year Period
US funds*, total annual returns, %
Top Ten in: 1996-1999	Same Funds in: 1999-2002
1	841
2	832
3	845
4	791
5	801
6	798
7	790
8	843
9	851
10	793

*With assets over $100m at end-1996 (851 funds)
Source: Bogle Financial Center, Lipper Inc

It is one thing to say that past performance is no guarantee of future results, but this data demonstrates that this year's winners may be next year's biggest losers. The chart above illustrates that the #1 annual return fund from 1996-1999 ended #841st out of 851 total funds in the subsequent 4-year period. In fact the best ranking for the previous top ten funds was 790th.

Expected stock returns tend to be highest when economic prospects look bleak, and lowest when economic prospects look bright. Active managers move in the opposite direction and when economic prospects worsen they want to reduce their equity commitments when they should be holding steady or increasing them and vice versa.
Active managers frequently reshuffle their portfolios in an effort to keep them stocked with the most promising securities. The costs associated with all these activities (research, trading, etc.) makes active management the most expensive investment approach, especially since conventional active management generates a much larger portion of its returns in the form of taxable capital gains. Additional returns to the investor are dependent on overcoming the financial hurdle created by the costs incurred from this constant trading.

Hurdles of Active Management (shown below):

1%	Operating Expenses¹
1%	Cost of Cash
1%	Transaction Costs²
1%	Market Impact Costs³
1%	Taxes⁴
= 5%	Hurdle of Active Management

¹John Bogle, Common Sense on Mutual Funds, p. 206
²Charles Ellis, Winning the Loser's Game
³New York Times, July 11, 1999
⁴John Bogle, Common Sense on Mutual Funds, p. 286

Passive / Indexed Management

Buy-and-Hold Approach because Markets Work

Passive/Indexed management refers to a buy-and-hold approach to money management. Passive managers believe that markets work and that in every asset class they choose, their best course of action is to accept market returns. Passive management makes no forecasts of the stock market or the economy. Many passive managers choose to use index funds to accomplish this management approach.

Index Funds allow People to Participate Intelligently in the Stock Market

Index funds, with low management fees and low turnover costs, always rank high in long-term performance studies. They have ranked in the top of their comparative universes since their inception, through the 70s, 80s and 90s. Index funds allow average people to participate intelligently in the stock market, by offering diversification and low fees.

Lower Trading Costs

Because investors cannot invest directly in an index, index funds offer clients an investable product that mirrors its associated index, and attempts to track its returns, less the cost of managing the mutual fund, or its expense ratio. Index fund managers recognize the impact of trading costs and probabilities for success associated with stock picking and market timing, and have chosen passive index management as an alternative.

Asset Class Investing

Passive management when applied to a client's entire portfolio is really asset class investing. This means investing literally in asset classes via passive portfolios that capture, in their entirety, the asset class or classes under consideration. Passive investing by its very nature is low cost (no research department), tax efficient (little turnover) and reliable (produces asset class returns).

Wealth Management LLC's Approach

At Wealth Management LLC, we are strong advocates of the passive asset class investment approach. And, while we understand that the basic tenets of passive investing fly in the face of most traditional investment strategies (and what most investors have always believed), we are convinced that a passive investment approach, which emphasizes broad diversification and market returns in a controlled risk, low cost, tax efficient environment is the right answer for individuals as well as institutional investors. We have found that this approach is translated best by Dimensional Fund Advisors into an array of mutual funds, each of which is rigorously designed to capture a particular "dimension" of asset class within a globally diversified portfolio. Check the links below for more information about Dimensional.