Market pundits have spent a great deal of time the past three decades endlessly debating the merits of “active” vs. “passive” investing. At its core, the argument can be distilled down to this:
Is it better for investors to employ elaborate strategies to try and outperform market benchmarks? Or is it better to abandon such costly strategies and simply track the market benchmarks using low-cost, index-type investments?
On this score, the passive investment approach has been shown time and again to be the hands-down winner against active strategies. In fact, the poor performance of active strategies is almost hard to believe – yet it’s true. This graph from the Wall Street Journal sums it up:
The bottom line, clearly, is that the active vs. passive debate isn’t much of a debate. Based on historical performance, if you go the active route you have a greater than 85% chance of underperforming the market when you pay up for a fund whose job it is, ironically, to outperform the market. There is a simple, logical explanation for this disconnect: Active management strategies can’t overcome their high costs (i.e., fund manager fees, trading costs, taxes, etc.). In a market that has become highly efficient in recent decades, active managers simply can’t deliver enough excess return over their cost of operation to justify their existence.
So, when given the binary choice of using active funds that have an extraordinarily high likelihood of underperforming their market benchmark or passive funds that are assured of tracking their market benchmark less their comparatively low fees, the logical choice is to use passive funds.
The problem with pure passive funds (like index funds), though, is that there is little or no management of the securities in the portfolio. Stocks are automatically bought when they are included in the specific benchmark the fund tracks, and sold when they are no longer included in that benchmark – regardless of whether it is an opportune time to buy or sell those stocks. Nor is any thought given to how those funds might work in the context of a larger portfolio strategy; the index fund simply tracks the index because it exists, whether it is a desirable asset class or not.
As it turns out, it isn’t a binary choice between active and passive. In our opinion, there is a third, better way to invest – and it’s one we’ve employed at Capital Directions for the past 25 years through the funds of Dimensional Fund Advisors (DFA).
DFA was founded by some of the most accomplished thinkers in the field of efficient market research, including Nobel Prize winner Gene Fama and Dartmouth professor Kenneth French. DFA uses the term “evidenced-based investing” to describe their approach, and while that may sound a bit jingo-ish, the proof of its success is in the numbers.
Over the past 15 years, only 14% of actively managed funds (across all categories) and 1% of passively managed funds have outperformed their benchmarks. (We would expect this of passive funds as they are designed to track their index less their management fees.)
In contrast, 73% of DFA funds have outperformed their benchmark over the past 15 years1.
Suffice it to say that is a remarkable track record, especially when compared to the futile efforts of actively managed funds to beat the market.
How does DFA accomplish this? By incorporating many of the best aspects of passively managed funds – low management fees, low turnover, style purity – with their own uniquely academic approach to portfolio construction and management. In their own words:
Rather than relying on futile forecasting or trying to outguess others, we draw information about expected returns from the market itself—letting the collective knowledge of its millions of buyers and sellers set security prices.
Letting markets do what they do best—drive information into prices—frees us to spend time where we believe we have an advantage, namely in how we interpret the research, how we design and manage portfolios, and how we service our clients. It means we take a less subjective, more systematic approach to investing—an approach we can implement consistently and investors can understand and stick with, even in challenging market environments.
DFA eschews subjective forecasting about where the market is headed and which stocks may or may not be in favor in the future – strategies that continually cause active funds to underperform. Instead, DFA focuses on identifying desirable risk and return characteristics that are specific to certain asset classes (such as small value stocks), and then creating funds to capture those risk and return characteristics as efficiently and inexpensively as possible.
That’s why we have been using DFA funds in our portfolio strategies since 1994. As investment advisors, it is vital that we use investment vehicles that provide accurate exposure to the most efficient asset classes at the lowest cost. With DFA funds, that’s what we get.
As fee-only advisors, we receive no compensation from DFA, or any other investment vehicle we use in our portfolio strategies. If another alternative comes along that allows us to give our clients better asset class exposure at a lower cost than DFA funds, we will use it. For the past two decades, however, DFA has consistently, and uniquely, shown us that their commitment to low cost, high quality investment management makes them the best investment options for our clients.
- Source: Dimensional Fund Advisors’ Mutual Fund Landscape Report. https://us.dimensional.com/#chapter1
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Just as the Federal Reserve Bank embarked on its mission to begin raising interest rates in late 2017, the gold bugs predictably emerged from the sidelines, touting gold as a safe haven from rising inflation and volatile markets. Advertisements hailing gold as a stable hedge in turbulent economic times flooded TV shows and websites, urging investors to pile into the precious metal to “protect themselves.”
Unfortunately, gold apparently didn’t get the memo. Despite rising interest rates and a surge in stock market volatility, the price per ounce of gold has marched steadily downward thus far in 2018:
Even worse, gold has generated a 0% return over the past five years, while the S&P 500 has gained about 70%. The problem with gold, as an asset class, is that it has no intrinsic value other than what investors are willing to ascribe to it. We know, say, Procter & Gamble has intrinsic value because we can look at its profits, sales and dividend history and assign a value to those metrics. But gold doesn’t provide goods or services and doesn’t produce any income, which makes valuing it an entirely arbitrary exercise among those who are willing to invest in it. In our view, that’s not the kind of investment we want in our portfolio strategies.
As the Oracle of Omaha, Warren Buffett, once wisely put it, “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
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We appreciate our relationship with you and look forward to speaking with you soon.