How Does Passive Beat Active? Let Me Count the Ways

Veteran ETF advisor Rick Ferri presents an exhaustive study finding that any meager alpha that active funds produce is simply not worth the risk

Warning: What follows is a lot of numbers, but the main takeaway is that it is indefensible for advisors to use active portfolios for their clients’ money because it is all but guaranteed that they will underperform.

That is one conclusion from an exhaustive study that veteran ETF advisor Rick Ferri presented at ETF.com’s Inside ETFs conference Tuesday in Hollywood, Fla.

Ferri, working with Betterment’s Alex Benke, published the study last year, comparing passive funds against 5,000 randomly selected active portfolios and viewing them across 32 different portfolio strategies.

The indexing solution won 82.9% of the time on average, and in the small percentage where active funds outperformed the median outperformance was 0.5%, leading the Troy, Mich.-based advisor to declare: “You weren’t paid enough to take that risk.”

He added that, theoretically, if outperformance were high, then investing in active funds just might be worthwhile despite the low probability of a payoff.

But outperformance, which varied across the 32 portfolio strategies, was never high, and Ferri pointed out that if an advisor correctly chose a winning active strategy, there was a high likelihood of giving back that alpha by realizing an even greater loss in an active category with large underperformance.

So, for example, if an advisor chose one of the few active bond funds that beat bond index funds — and the median outperformance of such a fund was just .23% in one of the scenarios — that same advisor choosing one of the losing active equity funds (and most active funds were losers) purchased a -2.01% median underperformance on the stock side.

In conducting the study, Ferri and Benke went out of their way to be fair by using investor share Vanguard funds (rather than cheaper Admiral shares) while scrubbing out the highest-cost active funds such as B and C shares, redemption fees and taxes; only no-load and A-share active portfolios were considered. They also used data scrubbed of no longer extant funds to further eliminate any bias.

Despite not factoring all of active funds’ potential disadvantages, Ferri says that passive funds outperformed in all asset classes and across time.

“The longer clients are in all-index portfolios, the higher the probability of outperformance,” Ferri said.

Just as more time improved the investment returns, so too did more asset classes improve results.

So in a test involving 10 asset classes, including such exotica as real estate investment trust index funds or tax-exempt bond funds, passive outperformance over active funds rose to 90% vs. 87.7% for three-asset funds.

This finding is particularly relevant for your typical 401(k) investor presented with a wide variety of fund choices, Ferri said, adding that a broad portfolio of active funds was merely providing “de-worsification,” a term he credited to Peter Lynch of Fidelity.

Unsurprisingly, when Ferri plugged in passive funds that had lower average fees than the ones used in his study, the results were even more lopsided. And when he plugged in the lowest-cost active funds, the gap narrowed.

In a nod to righteous active funds, Ferri conceded that if an active manager is within 50 basis points of an index fund, then the probability of beating the index fund rises to 50%.

“The bottom line is a fee. Fees matter,” Ferri said.

The advisor’s other bottom line was that the best active funds’ alpha is just too meager to justify those fees.

In response to a question from the audience, Ferri, whose study did not account for the effects of taxes, added that passive funds’ advantage over active funds would rise much farther still if taxes were considered.

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Check out How Indexing Distorts Investment Reality on ThinkAdvisor.

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