News

Even the Pros Can’t Beat the Market… But Don’t Fire Your Broker Just Yet

At the end of 2015, a story about Donald Trump circulated widely. According to reports, if he had parked his wealth in an index fund 30 years ago, he’d be more than twice as rich as he is now.

The math is simple enough. The S&P 500 grew 1,336% between 1988 and 2015. Trump’s real estate empire, meanwhile, grew just 300%.

The point, of course, is that it’s difficult to beat the market. Some financial wizards, like Warren Buffet, can do it. In the same time period, Buffet’s wealth grew 2,612%, twice the market average.

But for your average investor or fund manager, that S&P 500 benchmark is tough to beat.

In fact, 70%–80% of active funds underperformed their benchmark in the last decade. (Active funds are individual investments that are picked and managed using different types of analyses.)

The bottom line is that you can pay an active manager to pick the best stocks, watch the market every day, and hedge your investments. But you might still make less money than if you threw your cash into a passive index fund. (A passive fund is one that chooses stocks so as to imitate a major index like the S&P 500, Dow, or Nasdaq.)

This Argument Is Not New

Fund managers and academics have been going back and forth about the benefits of passive versus active investing for decades. And after a year when all three major US indices hit record highs, the debate is raging again.

The S&P 500, for example, made a return of 11.1% last year. Active managers would have had to hit a home run to beat that.

Then there’s the cost. Active funds charge big fees for their services, usually around 1%. That means active managers have to beat the market and then some to outperform an index fund.

A passive ETF (Exchange Traded Fund) that tracks an index can carry fees as low as 0.3%.

Simply put, passive funds often perform better, and they’re cheaper.

The Shift Is Already Happening

$285.2 billion moved out of active funds in 2016. Meanwhile, $428.7 billion moved into passive funds. Topping out a 10-year trend, a predicted $1 trillion will move to passive funds.

Active funds do still hold the lion’s share of assets, but for how long?

New rules from the Labor Department mean the active fund exodus is likely to accelerate.

In April 2017, a new fiduciary law will change the playing field. Managers of retirement accounts must recommend a strategy in the best interest of their clients. In many cases, it will be tough to argue that an underperforming active fund is in their best interests.

But Before You Call Your Broker…

Passive funds aren’t the silver bullet they often seem.

Of course passive index funds are thriving, we’re riding an explosive 10-year bull market. The S&P 500 has soared 232% since March 2009. Holding on for the ride is always going to work while the market is rising.

But what happens in the next bear market?

An active manager’s job isn’t just to beat the market – it’s also to soften the blows. A good fund manager will earn his money by buffering and hedging your downside.

A passive fund or ETF won’t give you that protection. If the market tanks, your money goes with it. An active manager, on the other hand, can step in to minimize the losses.

Due diligence is essential. Look for long-term performance, not just last year’s figures. Look for managers’ expertise in picking mid-cap stocks. Look at how they handle volatility and downside. Look for managers that invest their own money in their funds. Do not be swayed by flashy marketing.

ETF Horror Stories

There are a handful of horror stories that should also provide fair warning to passive investors. One man lost $2 million after investing in a passive ETF back in 2010.

A flash crash wiped out almost 1,000 points on the Dow Jones in just 15 minutes. Most investors didn’t notice a thing as the index recovered all losses shortly afterward. But ETFs took a battering.

Why? Because they are made up of complex financial algorithms to mimic an index. They are often futures based (i.e., a contract based on the future price of the underlying asset). That means they are susceptible to “contango,” a phenomenon where the initial buy price is higher than the “future” price. Over a period of time, your ETF may therefore diverge from the underlying index and decline, even if the index rises.

The losses are magnified if the ETF employs leverage (borrowing cash to multiply gains) and stop loss orders (to cut losses). For example, the previously mentioned flash crash caused the Dow to sink 9%, but many ETFs lost 60%. Losses were magnified; stop losses were hit and couldn’t recover.

ETFs are also growing increasingly exotic and niche. Safety is not guaranteed, and “passive” does not automatically mean “performance.” Investors would be wise to conduct the same due diligence they would with any other investment.

Finally…

Passive investments remove fundamental analysis from the market. They take out the human element. The brain.

Sure, computers and algorithms can calculate if an asset is oversold or overbought. But they can’t read and digest Microsoft’s annual report. They can’t analyze Apple’s new iPhone and determine its chances of success. They can’t understand changes in the political landscape or in public opinion.

Active managers are essential to providing this fundamental analysis and pricing it into the market. Without them, the market becomes less accurate and more volatile.

Bottom line: Passive funds may kick out higher returns and cost less. Especially in booming bull markets. Historically, stock prices rise over time, and to ignore them in your portfolio would be foolish. But don’t write off the nuance, experience, and safety of active funds either.

As always, due diligence, research, and careful thought are required before making any investment.

On another note, many clients first get to know us by accessing some of our well-researched courses and reports on important topics that affect you.

Like How to Go Offshore in 2024, for example. It tells the story of John and Kathy, a couple we helped from the heartland of America. You’ll learn how we helped them go offshore and protect their nestegg from ambulance chasers, government fiat and the decline of the US Dollar… and access a whole new world of opportunities not available in the US. Simply click the button below to register for this free program.

About The Author

Free Consultation

Since 1984, we’ve helped 15,000+ customers and clients build their wealth protection plan.

Book in a free no-obligation  consultation and learn how we can help you too.

Get our latest strategies delivered straight to your inbox for free.

Get Our Best Plan B Strategies Right to Your Inbox.

The Nestmann Group does not sell, rent or otherwise share your private details with third parties. Learn more about our privacy policy here.

The Basics of Offshore Freedom

Read these if you’re mostly or very new to the idea of going offshore

What it Really Takes to Get a Second Passport

A second passport is about freedom. But how do you get one? Which one is best? And is it right for you? This article will answer those questions and more…

How to Go Offshore
in 2024

[CASE STUDY] How we helped two close-to-retirement clients protect their nest egg.

Nestmann’s Notes

Our weekly free letter that shows you how to take back control.