JACK BOGLE: An Elegantly Simple Formula Shows Why Passive Investing Will Earn Higher Returns Than Active Investing
Passive investors aim to track the performance of a major index like the S&P 500. Active investors try to beat the index.
Unfortunately, active fund managers rarely beat the index. Even worse, they charge higher fees.
In an FT column earlier this month, David Smith, fund manager at Hargreaves Lansdown Fund Managers wrote that without active managers the world would be poorer and that passive management is a parasitic industry benefiting from the activity of the active investors.
In a new FT column, Jack Bogle, founder of Vanguard and a champion of passive investing, takes issue with Smith's characterization.
First, he points out the "elegantly simple formula" that investors should remember when it comes to passive investing.
"...Passive index funds typically own the shares of each stock in the market portfolio. Since active managers own all the shares that remain, they too, in aggregate, also own the market portfolio. Owning the same market portfolio, both active and passive managers earn the same gross return. Therefore, the group with the lower fees, lower transaction costs, lower administration costs, and lower marketing costs – namely, the passive index funds – will earn the higher net return. Every investor must keep in mind this elegantly simple formula: gross market return minus costs equals net investor return."
Bogle goes on to write that Smith's argument is inaccurate because it seems to suggest passive investing assumes the efficient market hypothesis, which posits that stocks trade at fair value and you can't outperform the market through stock selection.
"Mr Smith describes the index mutual fund as a “passive parasite”, rejecting the value of the innovation I created in 1974. He suggests that the index fund simply takes advantage of the market efficiencies created by active manager/traders. His article assumes that my confidence in the index fund is based on the “efficient market hypothesis”. This is not so. Whether markets are efficient or inefficient is beside the point. The cost matters hypothesis is all that is needed to explain why indexing works: gross return in the market as a whole, minus the costs of obtaining that return, equals the net return investors actually receive."
"Paradoxically, it is the active manager who is the real parasite," writes Bogle.
Read the entire article at the FT »