Perhaps one of the most prestigious advocates for two- or three-fund portfolios, otherwise known as lazy portfolios, John C. Bogle repeatedly contends that there is no evidence indicating actively managed funds outperform passively managed funds. The above quote makes his conviction clear: the market will always return to the mean. In other words, outliers that either grow big or fail hard will create a return of averages. This kind of logic is what has Bogle and others like him recommend two fund investment strategies in contrast to an active management of a portfolio. As Jonathan B. Berk (2005) states, “Proponents of efficient markets argue that it is impossible to beat the market consistently” (27). If this is the case, what is the alternative? What is the best way to utilize a lazy portfolio strategy? This short discussion examines this question in more detail, addressing both the pros and cons of passive versus active management strategies, which fund type is recommended for the beginning investor, and what type of indexation should be used by the same investor.
First and foremost, there are both pros and cons to a passively managed portfolio. There are two primary benefits for a passively managed fund. The main benefit is that index funds, by definition, simply grow along with the average growth of the entire market. As one article from Investopedia states, investors in index funds “select a fund that matches a well-known index, and then sit back to watch their investments grow with the market” (Wagner, 2016, n.p.). In other words, a two-fund lazy portfolio simply tracks the market growth over days, months, years and decades. In this way, the main benefit of a passively managed portfolio is that it all but completely guarantees growth over the long haul, since the market is always growing. Related to this, investors that utilize index funds experience more security in their investments. While the market may drop sudden, as was seen in 2008, logic says that it will always recover. After all, the stock market even recovered from the Great Depression. Therefore, a two-fund lazy portfolio keeps an investor’s investments growing and secure.
The secondary benefit to a two-fund portfolio is that index funds are not usually subject to the high fees associated with active investment management. As Berk (2005) states, “By managing a large fund and charging a fee that is proportional to the amount of assets under management, the manager captures all the economic rents generated using his ability” (29). Therefore, by making a self-selection for index funds, rather than relying on an investment manager, the average investor can save a great deal. In contrast, the only real ‘con’ of passive management is that investors could potentially miss out on large growths of well-performing stocks. Since index funds follow the market, passive investors are limited by the same law of averages that keep them safe. Therefore, passive funds may not fit the appetite of some risk- prone investors.
In this way, the primary benefit of actively managed funds is the same as the primary detriment of passively managed funds: they provide the opportunity for rapid growth if an investor chooses well-performing stocks. However, actively managed funds also come with detriments. As mentioned above, the main concern with actively managed funds is that they can actually underperform the market due to what are essentially bets on individual stocks. The other detriment is the high fees associated with actively managed funds, since they require human power to operate. For this reason, I would recommend a passively managed index fund strategy for the beginning investor. When someone is just starting out in the stock market, there is so much to understand – I would not recommend active investing or picking individual stocks to anyone who does not have any experience in the complex world of the stock market. Better to safely follow the growth of the entire market.
Related to choosing passive investing as a whole is the question of which indexation type is to be used. There are two primary indexation types: capitalization-weighted indexing and fundamentally weighted indexing. According to capitalization-weighted indexing, which utilizes efficient market theory, “a stock’s price reflects the market’s best estimates of the firm’s underlying true value at any given time” (Wagner, 2016, n.p.). In this way, capitalization- weighted indices (such as the S&P 500) attempts to identify the true value of a security primarily through cash flow. In contrast, fundamentally weighted indices consider not only capitalization and cash flow, but the fundamental aspects of the business, such as “sales, earnings, book values” and even dividends (Bogle & Malkiel, 2006, n.p.). In other words, fundamentally weighted indexing attempts to look at the securities of a company in relation to the rest of the company.
The main benefit of capitalization-weighted indexing is its apparent security. Because it follows the theory of efficient markets, this type of index is likely to continue to follow the true value of securities and the market as a whole. In contrast, the main benefit of fundamentally weighted indices is their substantial growth. As Bogle and Malkiel (2006) point out, “fundamentally weighted indexes have outperformed capitalization-weighted indexes” from 2000 to 2006 (n.p.). However, this “new paradigm” is based on a very short amount of time compared to capitalizationwe0ghted index investment funds (Bogle & Malkiel, 2006, n.p.). Therefore, the pro of capitalization-weighted indexing is the con of fundamentally weighted indexing, and vice versa. Based on this assessment, I would recommend capitalization-weighted indexes for the beginning investor, since these indices now have more than four decades of superior returns. Just like with choosing passively managed funds, low risk is the name of the game of the beginning investor.
References
- Berk, J.B. (2005). Five myths of active portfolio management. The Journal of Portfolio Management. Retrieved from: http://www.knightsbridgesearch.com/site/downloads/files/27.pdf
- Bogle, J.C. & Malkiel, B.G. (27 June, 2006). Turn on a paradigm? The Wall Street Journal. Retrieved from: http://johncbogle.com/wordpress/w- content/uploads/2006/08/WS]%20op-ed.pdf
- Wagner, H. (2016). Introduction to fundamentally weighted investing. Investopedia. Retrieved from: http://www.investopedia.com/articles/mutualfund/07/fw_index.asp
