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By Scott Burns | 09-01-2010 11:04 AM

The Power of Passive Investing

Rick Ferri's forthcoming book argue that the more actively managed funds you put in a portfolio, the lower the probability that the portfolio will outperform a portfolio of index funds.

Scott Burns: Talking about the power of passive investing.

Hi, there I'm Scott Burns, Morningstar's director of ETF research coming to you live from Morningstar's premiere ETF Invest Conference.

Joining me today is well-known author on the subject of indexing and asset allocation, and founder of Portfolio Solutions, Rick Ferri.

Rick, thanks for joining me.

Rick Ferri: Thank you, Scott.

Burns: Well, Rick you've always been a great authority on passive investing, whether it's about index mutual funds or ETFs as the author of The ETF Book. Now you've got a new book coming out, The Power of Passive Investing. What's this book about?

Ferri: This book looks at the probability of winning with a portfolio of actively managed funds versus a portfolio of index funds.

Now, many years ago, you didn't have a choice, you had to use actively managed mutual funds. But over the last 20 years, in particular, we've had more and more index funds, including ETFs, come to the market, which allow people to have an alternative. Instead of using an actively managed fund that tries to beat the market, they could use an index fund or an ETF at a very low cost that meets the market.

And we all know that it's very difficult for the active managers to beat the market. And the number that you hear out there is anywhere between 30% or 35%. But what I really looked at in this book is that a typical investor doesn't have just one mutual fund in their portfolio; they generally have five or even 10 funds, and if you put 10 actively managed funds in a portfolio, versus 10 index funds in a portfolio, what's the probability that the index fund portfolio will beat the active funds. And that's really where I was going with this to the next level with active versus passive.

Burns: Is there a new information in that, because we know that on average active funds underperform index funds. Costs and turnover and taxes, like that lead to what should be a 50-50 to be less than that. So, are we really – when you take 10 funds, I mean, isn't it just the immutable laws of mathematics where compounding, lower probability events and when you add them all up, you get a lower number? Or do you think that the general consensus out there is that those will offset?

Ferri: I think that the general consensus could be. I mean, I don't think a lot of people have done this. When I looked at the research, there was only two other studies over the history of basically 50 years of active versus passive studies, only two studies that actually looked at – looking at more than one fund.

So, one of the studies was done in 1995 and another study was done in 2005. They just gave you basic information.

So, I don't think this idea has come out enough of looking at it as a portfolio of funds rather than just one fund in the active versus passive debate, and that's really what I wanted to look at with this book.

Burns: And I think there's kind of a flipside to that too of just looking at one fund, there's also this aggregation of looking at all funds, which I always kind of find in the academic research there, academics love to kind of ignore the reality and the friction of the world.

But the fact that it presumes that you could buy all the funds that are out there. When really to your point most investors have a five-fund, 10-fund portfolio, and that's really what we should be focusing on. To your point, what are the odds if you been able to pick five to 10 managers that will outperform in that portfolio versus a low-cost index?

Ferri: Well, and the answer to that is what are the odds. And the odds are based on the number of funds that you have in the portfolio and the time or the length of time you hold the portfolio. And as it works out when you're looking at the numbers and you are crunching the numbers, the more actively managed funds you put in a portfolio, the lower the probability that the portfolio will outperform a portfolio of index funds.

And then the longer you hold that portfolio, it even goes down more to the point where you get out to about 20 years and there is less than a 1% probability that a portfolio with actively managed funds will outperform a portfolio of index funds.

Burns: That's kind of – definitely an interesting take. And I think it's going to give a lot of investors pause. Do you in your own practice use any active management at all?

Ferri: The only place we use active management is where there isn't any good low-cost indexing available. I'll give municipal bonds as an example.

We use Vanguard bond fund for municipal bonds that has 2,000 municipal bonds in it. So, it's very, very close to an index, I mean you could call it an index. Because when you look at the municipal bond index funds, they generally at the most have only a couple of hundred bonds in it because of liquidity. So, it's the market, the municipal bond market makes it very difficult to index in an index fund.

So, in those cases we do look at the active management, but not because we think active management is going to beat indexing, it's only because that's where you can get broad diversification at a very low cost.

Burns: So, were there any anomalies or any bright spots for active management in this study? I don't want to totally pile on that.

Ferri: There's always the possibility of outperforming, it's just a very low probability.

Burns: Right. We actually, we looked at some of those numbers there, and I think that's actually the most striking thing is that in a sense the probability is low – call it a third, and the risk return or the positive-negative payouts are uneven in a way that it's actually not a fair game, right?

Ferri: That's exactly right. I mean, if you go to the next derivative everyone looks at what's the probability that a fund will outperform. And you're right it's about 30% to 35% over a five-year period of time that any actively managed fund is going to beat an index fund in the same asset class.

But that's only half the story, the other half of the story is it would be OK to buy an active fund or try to find an active fund if the payout for finding an active fund was high enough.

The problem is that, it isn't. If you have two thirds of the funds underperforming and one third of the funds outperforming, and those two thirds are underperforming by say 1.5% per year on average, and there is a two to one ratio, then the ones that outperform have to outperform by 3%, which is just double 1.5%. But when you look at the actual outperformance, it's closer to maybe 0.7%. It doesn't get anywhere close to what it needs to be to be a fair game.

So, it's not only a low probability, it's a low payout. And then when you multiply that over a series of funds, now you've got a portfolio that's just destined to underperform if you're using active management.

Burns: Well, devastating stuff for active management. Well, I could see how they respond to this powerful study on your part.

So, Rick thanks for joining us and good luck with the book. Soon to be out there, The Power of Passive Investing.

Ferri: It will be out by Thanksgiving.

Burns: All right, thanks. I'm Scott Burns with Morningstar. Thank you.

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