The Power of Passive Investing

“Passive investing is power investing.” This line from Richard Ferri’s book The Power of Passive Investing: More Wealth with Less Work is proof that he’s far better at persuading people to use index investing than I am. Who wouldn’t want to be a power investor?

Ferri goes through the academic evidence and makes the case for passive investing to individual investors, charities and personal trusts, pension funds, and advisors. The typical individual investor will get the central ideas of this book, but it’s mainly aimed at much more knowledgeable investors.

Ferri takes dead aim at the “utter failure of active managers to deliver on their promises of market beating results while enriching themselves with fees extracted from investors who entrust money to them.”

“A fund that tracks an index may charge only 0.2 percent in annual fees compared to an active fund with the same investment objective, which may charge 1.2 percent per year.” Over 25 years, these costs grow to 4.9% and 26%, respectively. But Ferri is focused on U.S. funds. In Canada, we often pay about 2.5% per year (46% over 25 years).

Ferri estimates that “tactical asset allocation errors cost investors about 1 percent per year.” Doesn’t this mean there is someone on the other side of these trades making money at tactical asset allocation? Perhaps not depending on exactly how this cost is measured. I find I’m often left with questions about exactly how some statistics are calculated.

One section of the book quotes results from DALBAR on the eye-popping gaps between mutual fund time-weighted returns and the money-weighted returns of actual investors. I’ve written before about how DALBAR’s measure of investor underperformance is wrong. Fortunately, the rest of the evidence in this book supporting passive investing doesn’t depend on DALBAR’s results.

Ferri has some counter-intuitive advice for you: “Avoid strategies that promise to deliver excess returns and you will earn higher returns.” Investing is an area where trying harder can make things worse.

As for finding a talented active manager to handle your money, why would someone capable of beating the market need your money? “If an active manager were talented, chances are you’ve never heard of him or her, and if you did, you’d never be able to hire them.”

Ferri believes that advisors cling to active management “because they believe it’s what their clients want.” But he says “Individuals who go to an advisor aren’t looking to beat the markets. They’re looking for prudent investment advice that’s appropriate for their needs.”

“When an inexperienced person visits an advisor for advice and councel [sic], it is the responsibility of the advisor to disclose how they are paid up front.” No advisor I ever worked with passed that test.

Overall, Ferri does a strong job of presenting evidence for the superiority of passive investing, but few investors would have the patience to go through it all. More likely, Ferri will persuade a group of more knowledgeable investors, and some of them will take a simplified message about passive investing to individual investors.