Reading Notes -- Passive Investing EP01 --- By Aga

About half a century ago, investors had few types of funds to choose from. They could only invest in active funds. Fund managers were responsible for selecting stocks and entering and exiting the market at the right time. The fund market changed dramatically in 1976. Vanguard launched the first passively managed index fund tracking the S&P 500 in the market in 1976. Passive funds directly challenged active funds. .

The author points out five major deficiencies of active funds through a large number of academic research examples.

1) Relative performance

Compared with Vanguard's S&P 500 index funds, only one-third of the surviving active funds performed better, while two-thirds of the active funds performed poorly. Some people will challenge that as long as they can select performance-oriented active funds, they can beat the market and earn excess returns. But predicting the performance of fund managers is often an impossible task. The study pointed out that there is no indicator for investors to choose a fund manager with excellent investment ability, and finding a talented investment manager has become a matter of luck. Moreover, if active funds are added to the portfolio, the overall portfolio performance will be reduced. Furthermore, the longer you hold an active fund, the less chance you have of a positive return.

2) Unfair compensation returns

Since the fund's win-loss ratio is 1:2, a winning active fund should, on average, return twice as much as a loser's loss. But historical data shows that winners have an average return of 0.96%, while losers have lost as much as 1.69%. This is clearly an unfair rate of return. If you unfortunately have both good and bad funds in your portfolio, it will be difficult for the winning fund to earn the losing capital.

3) Risk

Active funds that can outperform the Pilot Benchmark 500 index funds become rarer when return comparisons are made after risk adjustment. Traditionally, there are roughly three factors that depend on the risk of a portfolio, the market factor, the size factor and the value factor. Market factors are cyclical highs and lows in the securities market. The size factor is that smaller companies with less market capitalization generally have higher pay than larger companies. The value factor is that value companies with lower market-to-book ratios will have higher excess returns. If the fund does not have excess returns on a risk-adjusted basis, then the fund manager is not particularly capable, since the same returns can be easily achieved by having a portfolio of market-wide index funds, small-company index funds, and value-company index funds.

4) Sales commission

Basically, most of the fund management companies in the market need to charge investor commissions as compensation, and the commissions charged by active funds are generally higher than those charged by passive funds. When comparing fund performance after commissions are deducted, the Vanguard 500 index fund outperformed 88% of active funds.

5) Taxes

Active funds usually have a higher turnover rate. Due to more frequent trading, the tax generated will be higher, which will affect the return of the fund.

The author uses a lot of examples and academic research to bring out an investment focus. Instead of believing that the fund manager can earn you excess returns, it is better to put your money in passive index funds. Because under the same risk, passive portfolio is the investment strategy with the highest success rate.