Ferri, The Power of Passive Investing

The title says it all. In The Power of Passive Investing: More Wealth with Less Work (Wiley 2011) Richard A. Ferri makes the case for building a diversified portfolio of index mutual funds and ETFs.

He cites several studies and some of his own tests that demonstrate the futility of seeking alpha. Among the findings, a single actively managed fund has a 42% chance of beating a comparable index fund over the course of a single year, a success rate that drops to 12% over 25 years. The statistics get much worse as you add more active funds. If you own ten funds, you have a 27% chance of beating an all index fund portfolio over one year and a mere 1% chance over 25 years.

Ferri’s own work analyzed the returns of actively managed funds within a generic asset class over five years. He found that a portfolio of five randomly selected active funds had only a 16% chance of beating an index fund, that only 5% of them won by 0.5% or more, and that 63% of them lost by 0.5% or more. When the portfolio was expanded to ten active funds, the numbers were much worse. Only 8% were winning portfolios, 1% of them won by 0.5% or more, and 70% lost by 0.5% or more. Ferri then massaged his model to see whether the numbers could be significantly improved; they couldn’t. As he summarized the results, “Active fund investors have strong headwinds against them. The probability of selecting a winning fund is low; the average payout for those winning funds does not compensate them enough for the shortfall from being wrong; the addition of several active funds in a portfolio reduces the probability of success; and the longer that portfolio is held, the odds drop even more. That’s a lot of headwind!” (p. 92)

Market timing strategies are also unsuccessful. The worst strategy, using survey data from a large sample of online brokerage clients, is trading based on technical analysis or charting (a negative 0.92% per month). Trend following—that is, shifting money into asset classes that have recently gone up and taking money out of those classes that have gone down—costs investors about 1% a year.

Passive investing, as the title indicates, is “power investing”. (p. 157) The process of implementing a passive investment plan is fairly straightforward. Here I’ll mention only the bucket approach to asset allocation where “one bucket holds cash-like investments for short-term needs and the other bucket has long-term investments that refill the short-term bucket when needed.” (p. 163)

Ferri rounds out his book by looking at passive investing for charities and personal trusts, pension plans, and advisors.

The recommendations in this book are not revolutionary; John Bogle has been making the case for index investing for decades. The recent proliferation of asset class index ETFs, however, has made it much easier to customize portfolios to individual investing profiles.

The real problem, the author says, is not to implement a passive investing strategy. It is to convince people to change their ways, to realize that they’re highly unlikely to beat the market, and to accept the wisdom of being satisfied with market returns (however the markets are sliced and diced).