157 days! More than four months! That is a long time since I’ve written my last post, and a lot of time for people (mainly my friends) to ask me when I’m writing my next one. Thank you, everyone, for your patience. A lot has changed in these 4+ months for the markets. Rather than getting into that, let’s talk about a long-lasting trend that hasn’t changed: the move towards individuals’ passive investment in S&P 500 index funds.
I really like this graph, and it summarizes well the journey stock ownership has taken in America over the past 80 years. To start, we see a huge shift in the number of stocks owned individually by households throughout. What has taken its place has shifted throughout time, with the stocks still primarily benefiting American households through intermediaries.
The Active Intermediaries
The first intermediary to have taken over was pension and government retirement funds, peaking around the mid-1980s. Employees relied on their respective employers to manage capital on their behalf and provide them with the benefits of that management when they retired at fixed rates. Meanwhile, those managing the pensions actively traded in and out of stocks looking to generate “alpha” (above-market returns), collecting fees, and negating each other’s efforts.
The next wave of intermediaries to invest on behalf of the public were the active mutual funds. The major difference between these funds and pensions is that individuals picked these fund managers, rather than companies choosing the pension fund managers. Additionally, withdrawal at retirement isn’t set at fixed rates but is on the individual to decide their withdrawal strategy.
These funds looked like they peaked in the mid-2000s, though they still have a big present market share. They essentially did the same thing as the pensions regarding stocks, trading in and out of stocks to beat their peers. Most of the time, the active mutual funds that significantly outperformed drew a lot of attention and capital, then inevitably, their performance worsened (mean reversion of their strategy, drawing more competition, more capital increasing the size of companies to invest in).
All in all, the average active mutual fund performed averagely. The investors in those funds got the market’s average performance minus fees and taxes.
Enter Passive Intermediaries
The next intermediaries I’ll spend the rest of the article discussing are passive mutual funds and ETFs. For practical purposes, I’m lumping them together, as only 2% of ETFs (exchange-traded funds) assets are actively managed – representing just 0.16% of our chart. The move to passive was spearheaded by the firm Vanguard and its founder Jack Bogle. I can write three posts about how indebted we are to that firm and Jack for revolutionizing the space, but I’ll save that for another time.
What’s important to know is that there is now a significant movement of individuals investing in mutual funds and ETFs whose simple goal is to get the same return as the market. The most popular of which tracks the S&P 500 index, a collection of the 500 biggest companies in America. The makeup of which is weighted by the size of the company.
What is most important here is just like the active mutual funds, the investors in these funds get the average market performance (by design) minus fees and taxes. However, the investors will receive a much better share of market performance as these funds minimize fees and taxes. Rather than having a bunch of managers charging high fees, making taxable market transactions, and competing away each other’s results – with passive investment, an investor buys a share of American business and holds on.
Bear Market Prompts Reconsidering Strategies
“Everyone has a plan until they get punched in the mouth.”
Mike Tyson
The stock bear market of 2022 was marked official in mid-June and is still ongoing. This long period is many people’s first real test of the merits of the buying and holding S&P 500 funds as a strategy. We saw in the above graph that passive investment was nearly nonexistent in ’08, during the financial panic and last long bear market.
So we’ve got punched in the mouth by the stock market, inflation, geopolitical tensions, you name it. Many of us are reconsidering strategies; I can see the anxiety written in many semi-anonymous public forums and conversations with those around me. Should we keep on investing passively in the market? Consider the rest of this article a defense of passive investment and an encouragement to continue with passive investment plans.
Passive Investment Outperforms Active Investment
The average passive investor will outperform the average active investor. This is a mathematical certainty as true as E = mc^2. Put simply, the average market investor will receive the market’s average return minus fees. The average passive investor will have less fees than the average active investor and thus will win every time.
This is all very theoretical (and I hate theoretical writing – that’s why I blog), so let’s make this more concrete by sharing an example.
S&P 500 Index Fund vs. Active Investment Example – Past 10 Years
I’ve taken some creative liberties in the making of this chart. However, the analysis is rooted in using some of the previous research done by John Bogle in his book The Little Book of Common Sense Investing.
The gross annual return shown on both sides is the return the S&P 500 Index has had for the past 10 years. The S&P 500 Index Fund (looking to exactly copy the namesake index) has substantially less fees, estimated at a 0.09% expense ratio on average by Vanguard. While the active mutual fund has an estimated .5% expense ratio (in the book, this was 1.5%), an additional 1% expenses based on fees from the buying and selling of stocks in the portfolio, and an estimated .5% in upfront sales charges; all in all, totaling out to 2% fees.
The last part of the chart shows the returns after fees taken out by the two different types of investors from hopping into and out of funds at the wrong time. In the book, John researched and found that in 1995 – 2005 passive fund investors lost about 2% a year. Meanwhile, active mutual fund investors lost about 8.2% a year. If you think these results are too extreme to apply to the present day… maybe you’re right. Personally, I’d take the opposite side of that argument, just look at what’s happened recently to active funds like ARKK.
A Stunning Story When Compounded
Continuing with the example, when you compound these results over the years, they speak for themselves. Over 40 years and extrapolating out the past 10 years’ returns, $1K would grow to $55K with the S&P 500 investor and only to $2.5K with an active mutual fund investor.
A Framework for Estimating S&P 500 Forward Returns
I painted a fantastic picture in the above paragraphs, but let’s get more realistic and technical. It would be foolish to extrapolate the last 10 years of a very strong stock market and say that’ll continue for another 40. So for those interested in playing the long game and continually buying and holding an S&P 500 Index Fund, what are the returns you can expect?
Proxy for Determining S&P 500 Returns
S&P 500 Annual Return = S&P 500 Dividend Yield + Real GDP Growth + Inflation
Here is a proxy I like to use when I think about the forward returns for the index. Present day I’d approximate this out to be 1.8% dividend + 2.0% real GDP growth + 2.0% targeted inflation. So I’m expecting around 5.8% a year from the S&P 500 going forward, +/- 2%.
Looking backward to 1992 (to include full bull/bear cycles), the result of this analysis would look like 2.8% dividend + 3.6% real GDP growth + 2.2% inflation, estimating 8.6% a year. The actual S&P 500 20-year return instead was 9.5% a year. Close enough for me to say my formula is reasonable for a quick proxy.
Something to note is that this proxy doesn’t include increases/decreases in price-to-earnings multiples for the index or an expansion/decline in corporate profit margins (profits outpacing GDP growth). Depending on economic circumstances these could be big misses, but remember I’m a blogger not an academic writing a research paper.
Putting Theory into Practice
If this article made you excited to continue with your passive investment strategy or has you looking to start, congratulations, you’re also an investing nerd like me! To play the long game with passive investing, identify the index you want to track. I like the S&P 500, but there is also the Total market Index, Dow Jones Industrial Average, MSCI World Index, and Nasdaq Composite.
Once you find your preferred index, pay close attention to the expense ratios they come with. Pick out your favorite fund, I like Vanguard, and set a regular transfer from your checking account to purchase the fund. Do your best to reduce adverse selection losses (jumping in and out of funds), though if you’re buying passive investments, you should be halfway through that battle.
Disclaimer: I am currently not invested in passive investments, as I enjoy the process of individual stock picking. I will explain my rationale for my strange behavior in the next blog post. I have unique personal investing biases that are listed here.