Passive Investing vs. Active Investing

A popular debate investors like to squabble over is whether to invest passively into Index Funds or to utilize investment managers who take a more active approach to money management. There are going to be a few key differences between the two. First and foremost the index funds, like their name suggests, simply track an index (i.e. the S&P 500, or Russell 2000). Often times these funds utilize software devices to do the tracking for them. Active managers on the other hand will pick and choose stocks on their own requiring much more time and effort on their part. Due to the extra work required of active managers higher expense ratios can be expected. With these higher expenses come a required higher rate of return just to break even with their rival index. So the big question you have to ask yourself is not whether a manager can match his or her benchmark, but rather can he beat the benchmark by a greater amount than the expenses. Investment managers will often tell you yes they can because they got experience, and a piece of paper that says "CFA" (which merely means they read a lot theories and passed a couple tests) Now I'm not docking the CFA, it is an extremely hard test and requires a lot of work and knowledge, but a recent look at history will tell us that the certification doesn't equate to a crystal ball.

Take a look below at the stats from Morningstar to judge for yourself whether or not managers hit their mark in the past 12 months.

• Only 26% of large cap managers beat their benchmark
• 37% of mid cap funds beat their benchmark
• A measly 20% of small cap funds beat their's
• Worst of all only 17% of bond managers was higher than the benchmark
• Of the 18 sub-categories in this research only 3 categories outperformed

What does this mean? It means that a lazy investor could beat over 75% of professionals by simply choosing to go with index funds. How is this possible? It is possible because most actively managed funds over charge their customers in fees and commissions. Now am I suggesting to never go with an actively managed fund? Hell no...some fund managers are real professionals and are reasonable with their expenses. For example, Donald Yacktman of the Yacktman fund in the last 3 years have returned his clients nearly 23% compared to the S&P 500's 8%. Yacktman has outperformed the index nearly every single year and charges less than 1% to investors.

If you are going to choose an actively managed fund you have to do your homework. There are a few all-stars here and there that consistently beat the market, but remember historical performance is not always an indicator of future outcomes.

Next week I'll share with you how a lazy man can not only diversify risk, but outperform the market. Remember it is better to think smarter than to work harder.

Utilizing No-Load Funds

Some of the big questions in investing include, should I use mutual funds or individual stocks?

99% of investors use mutual funds because that is what they were told to do, or because that is all that is offered to them. There are certainly some advantages to them that advisors will boast about, such as the instant diversification, the simpler handling of transactions, etc.

Here is the problem I see with them, they don't actually give you the diversification advisors claim they do and on top of that they'll charge you for it. Mutual Funds in addition to having commissions they charge an annual expense ratio typically around 1%. So not only do most funds take 5.75% right off the top for commission, but they also take 1% each year, meaning, just to match the benchmark you have to beat it by so many 100s of basis points each and every year. As for diversification most mutual funds will hold anywhere from 50 to 500+ stocks and specialize in a certain industry, sector, or asset class (i.e. large cap stocks, or small cap stocks). The main objective in holding more stocks is to take away the specific risk of an individual company failing. Obviously if you hold only one stock the chances of you losing money is a coin-flip. There gets to be a point though when adding additional stocks doesn't really mitigate any additional risk, it is like the law of diminishing returns in economics. The more you add the less of a drastic result of diversification you receive. No matter how many companies you hold you will never be able to diversify away systematic or market risk - stock markets crash sometimes because of forces outside of individual company's control. See the graph below.

Now would I go so far as to say all mutual funds are bad? Of course not. I wouldn't advise an individual to hold stocks if he or she is just starting out in investing. Here is why:

• Investing seperately in 25 stocks requires a substantial amount of money
• Commissions per trade add up
• Studying individual stocks requires a lot of time and knowledge because there are so many moving parts to a company that you don't see or hear
• The volatility of individual stocks can be extreme

So what is my suggestion? No-Load Funds.

There are funds out there that don't have a front-load charge, or a back-end charge. Mutual Fund companies pay the salesman because he does the marketing for the company. Yet if you do a little bit of homework and research for yourself -- which you are doing right now -- why should you pay someone else?

95% of Mutual Funds are -- excuse my french -- complete horse-shit. But there are a few that have really good managers, which professionally pick and choose stocks for you, they have access to much more information than the average joe, they have a track record, and best of all you can find some that even keep their expenses lower than 1%

Please if you have any questions or comments leave them below, or contact me.