Debunk Passive Investing As The Holy Grail
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80% of actively managed mutual funds under-perform the benchmark over a long period.
Although there is a truth to this adage, one has to peer beneath the surface instead of simply painting over the entire mutual fund spectrum with the same brush. There is always a flip side to a story. If you’re up to the challenge, read this long article on how closet index funds are contaminating the statistical finding.
Occasionally, the underperformance of fund managers vs. the index is trotted as evidence of the efficiency of the market. However, this confuses the absence of evidence with evidence of the absence. A new study suggests that closet indexing accounts for nearly one third of the US mutual fund industry. Stock pickers account for less than 30% of the market, yet they have real investment skill.
Before going further, I’d like to emphasize that I’m a proponent of passive investing. ETFs and index funds are the way to go if you’re looking for something easy, effective, cheap, and tax-efficient. While I don’t deny the merit of passive investing, I believe the market is very inefficient, and investors do get blind sided by the occasional market bubbles. Remember the TSX losing half of its value during the dot com carnage?
The correction taught us a lesson that performance isn’t everything. Let’s throw in a simple example of choosing between investment A and B. Investment A has a chance of making $100, but you must risk $50. Investment B has a chance of making $90, but you must risk $20. Investment A has a higher expected return, but investment B has a higher risk-adjusted return. Below is a comparison of TSX versus Chou RRSP over a 21 year period. You can see clearly that Chou RRSP’s line is much smoother. Since the manager, Francis Chou, is a renowned deep value investor, he builds a margin of safety on all his purchases. With this process in place, Francis Chou tends to give you a more consistent and steady return as evidenced by during the tech bubble. As a bonus, Chou RRSP did come out ahead of the index and with less risk/volatility.
This is not a post against passive investing. Remember that passive investing is not a religion. You can buy good quality actively managed funds like Chou RRSP without letting go your index funds and ETFs.
Disclosure: I have held Chou RRSP for 2 years, and am planning to pick up Chou Associates soon. This is not a recommendation to buy.
Source:
- Chou RRSP (GlobeFund.com)
I also (in the last year) got into the two chou funds, seduced by gordon papes recommendation and of course the returns over two decades. And I’m having a Homer D’oh moment when i see the dolar rise and the share price fall. With the Associattes fund I can understand and see the Berkshire holdings etc. But of course when I examine the rrsp fund holdings I see better but am still surprised when I see the tsx soar yet the fund is unaffected. I’m just surprised that the rrsp fund really has no connection to the index but I did buy it for diversification from other holdings so I’ll stop bitching.