Session 37 (of 42): Passive Investing Choices

0:00 Hi. Welcome back. In the last session, we looked at how difficult it is for active investors to beat the market. Most mutual funds don't do it. Most individual investors don't do it. In fact, they spend time and resources and often end up earning 1%, 1 and 1/2%, 2% less than what they'd have made with no effort at all. So, in this session, I want to focus on what happens if you go down the passive investing route. We decide that you're not going to go out and do active investing.

0:31 If you make this decision to be a passive investor, the first thing to do is not beat yourself up. Many people view this as giving up. You're not. You're accepting a reality that winning at active investing is difficult to do and maybe it's not your thing to try. So, the choices on passive investing boil down to three. First is a classic index fund. The very first index fund was created by by Vanguard in the 1970s, Jack Bogle.

1:00 Essentially replicating the S&P 500. Since then, the index fund business has exploded. There are hundreds of index funds indexing pretty much every single index you can think of. Small caps, large caps, by geography. So, we'll start with classic index funds. What they do, how they construct it. Then we'll move on to what I call enhanced index funds. Along the way, we'll stop and talk about exchange-traded funds, which have increasingly over the last two decades become alternatives to classic index funds for many investors.

1:37 So, let's start with a classic index fund. A classic index fund, if it's fully indexed, is a very simple creation. Here's what you do. You first start by by looking at the index you want to replicate. Let's take an example. Let's assume you want to replicate the S&P 500, the most followed and tracked index in the world. The second choice you have to make is what you're going to weight your index fund on. Most index funds, if they're constructed according to at least basic theory, are index based on market cap. So, you're going to collect the market capitalization of every one of the S&P 500 companies.

2:16 But, there are alternatives. You could create an index fund weighted based on revenues. Large revenue companies are weighted more. We can have an index fund that's not weighted at all. It's an equally weighted index fund. The market cap weighted index fund is the most common, but the alternatives exist. Third, you created a weighted portfolio of the stocks in the index. So, basically, you take the 500 stocks in the S&P 500 and hold them in proportion to the market cap given how how big your fund is. That's a fully index fund.

2:48 Now, fully index funds, obviously, are the right way to go if you truly want to be just like the index. But, sometimes creating a fully index fund might be practically expensive or very difficult to do. Let's see why. Let's suppose you want to create a global index fund. You want to hold every traded stock in the world in proportion to its market value. It's going to be tough to do, right? That's 46,000 companies. There, what you might instead get is a sampled index fund. What's a sampled index fund?

3:21 Instead of getting all large cap stocks, you might take 20% of the large cap stocks. Essentially, sample each grouping based upon its place in the overall index. What you will get with a sampled index fund is something that moves very much like the index. The statistics work in your favor. So, even if you own only 4,000 global stocks and there are 46,000 out there, if you created the sampling right, that 4,000 stock index fund should move very much with the overall index.

3:55 But there will be gaps. So that's index funds have been around a long time as I said from the 1970s. And we go to a site like Vanguard, the leading index fund company in the world, you can pretty much index whatever you want. If you want an exposure to small cap stocks, you can find an index of just small cap stocks. If you want to replicate a value fund, you can replicate a value portfolio of low price to book stocks, you can find a value fund.

4:22 Essentially index funds can capture whatever you're trying to do. And over the last few decades, index funds have increased their share of the overall market. We talked about why the last session. It's because active money managers have underperformed the market and eventually people investing with those active money managers decide that this is not worth it to pay somebody to lose money for you, and they move their money to index funds. As a percentage of total money invested, index funds have increased from 3.7% in 1993 to 14.2% in 2010 to almost 24% in 2024.

4:59 Along the way, as I said, the number of index funds has exploded. But the the other way to passively invest is exchange-traded funds. We'll talk about that next, but exchange-traded funds have exploded even more. They've gone from almost nothing in 1993 to almost 44% in 2024. Combining index funds and ETFs together as passive investing, passive investing now accounts basically there for almost 68% or 67 to 68% of all money invested.

5:35 If this were a battle, passive investing is clearly winning. So that's traditional index funds. So let's talk about alternatives to traditional index funds. I've mentioned exchange-traded funds. I'll talk about what ETFs are and why some people might choose them over an index fund. You could use index futures and options and effectively leverage your bets on the index. Basically, you're still playing a passive investing game, but using futures and options. There are enhanced index funds. What these try to do is have their cake and eat it, too. So, they're an index fund, so they have the low costs, you're not selecting stocks too much, but you take a subset of the index. Why that subset? Because you think it's going to outperform the index. That's what I mean by having your cake and eating eating it, too. You're going the passive investing route, but you're still trying to get that extra return from being an active investor.

6:27 Let's talk a little bit about exchange-traded funds. With exchange-traded funds, you get many of the benefits of investing in index fund, but you get the added liquidity. Now, where does that additional liquidity come from? Unlike an index fund, which is marketed by a Vanguard or a State Street, you got to go through that entity to get rid of what you own or to add more. With an exchange-traded fund, which is listed in the market, you can actually buy and sell at the current price. So, if that is something you value, you might use an exchange-traded fund over an index fund.

7:01 Now, when we talked about market timing, we talked about how people can use index funds to time the market. If you're truly timing the market, you might need that additional liquidity and need it quickly, so you might go with an exchange-traded fund instead. The costs of exchange-traded funds are slightly higher than index funds, especially if you're a long-term passive investor. So, you're asking, "Should I go with an index fund or an exchange-traded fund, assuming that both are offered?"

7:28 If you're a long-term passive investor, you're investing in index funds because you want to keep your costs low and you have no desire to time the market or pick stocks, index funds will work better for you. If you're investing in index funds because you still want to time the market in the background. Get in and out of markets, you might prefer an exchange-traded fund. The final choice is enhanced index funds. There are three ways in which you can bypass traditional index funds. The first is you can use derivatives, futures, options, swaps to create what looks just like the index by combining a derivative with some kind of borrowing or lending. If I sound mysterious, go back and review what we talked about in the context of arbitrage. We talked about how you can create a replicating portfolio using call option and borrowing.

8:20 Essentially with a synthetic enhancement strategy using derivatives plus something to make to create something that looks like an index. You're saying, "Why would I go to that trouble?" Maybe you can replicate the index and earn a slightly higher return because something is being mispriced. So already you can see a theme emerging with an enhanced index fund. You want the benefits of being passive plus an extra bonus, an additional return. The second way you can create an enhanced index fund is a little trickier.

8:51 Basically, you take an index and rather than weighted based on market cap and buy every single stock in the index, you might leave out a few stocks. Why? Because you don't think they're good stocks. Already you can see with an investment-based enhanced indexing strategy, you're bringing in an active investing component. You believe small caps are going to outperform large caps. So what do you do? You tilt your index towards small cap companies. You believe low price-earnings ratio stocks are better than high price-earnings ratio stocks in the long term. You tilt your index towards the low PE stocks. You can do that either by taking the high PE stocks out of the index or as is more commonly done, altering the weight so low PE stocks are weighted more.

9:34 So you're trying to get the benefits of indexing plus the additional returns from being an active investor. And finally, in quantitative enhanced indexing, what you do is you take an index and rather than weight based on market cap, you draw on portfolio theory. In portfolio theory, there is this version of maximizing returns for a given level of risk using optimization techniques. It's called a Markowitz portfolio. Basically, you can do the same thing. You can take an index, you can compute the expected returns and standard deviations of every stock and create some kind of optimization approach that gives you the index but better weights on the index. The weight The weights that supposedly would deliver better returns or higher returns in the future. But again, to emphasize with enhanced index funds, you're trying to get the benefits of passive investing, low cost, not too much activity, plus additional returns because you're picking individual stocks.

10:31 It's worth noting, though, that many so-called active funds are really enhanced index funds because they hold so many stocks in the index that by the time you're done, you look at that active fund for which you're paying a fee and pay paying managers to manage it, they're only 493 out of the 500 stocks in the S&P 500. They call themselves a large cap fund and charge you 1%. Effectively, you have an enhanced index fund. So, this is actually a graph that looks at Fidelity Magellan fund over time with different managers in place. When Peter Lynch managed the fund, it was a small fund. You can see it was primarily an active fund. You're picking stocks.

11:16 As the fund got bigger, and this becomes the theme that pushes these big funds into becoming enhanced index funds, you can notice that the active portion drops off. In fact, under Robert Stansky, who managed the fund from from late '90s to the middle of the 2000s, you can see it became almost entirely an index fund. The The active portion became a very small percentage. Harry Lang, so when you got a new manager in, you can get the active portion up. Whether that this is good or bad to increase the active portion depends on the returns. Maybe what Stansky was doing was actually the right thing to do.

11:53 Though then you're asking, "Why am I paying the fees for an active fund?" So with that said, let's go back to enhanced index funds. Over the last 20 years, there has been this group of funds that are that promise that they can deliver the low cost of index funds plus those extra returns. The one thing to that they promise those higher expected returns and at least in practice, if you look at what they delivered, it looks like you know, some years at least they deliver more, but some years they deliver less.

12:26 So historically, they've outperformed the market, but with a very slight outperformance. And here's the catch. That outperformance comes with slightly higher risk. So the bottom line is enhanced index funds deliver slightly higher returns than traditional index funds and have slightly higher risk, are you really better off? In fact, you could argue that over time enhanced index funds have not delivered on their promise. That, you know, that they actually become effectively index funds with slightly higher cost and over time lower returns.

13:03 So here's the bottom line. If you decide to go the passive investing route, be proud of it. Don't don't be defensive. It is your choice. It is your money. And if you feel over time you're not going to deliver the returns from actively picking stocks, it is the right choice for you. Along the way, if you decide you want to be a little active, and almost every passive investor wants to be a little active, you can accomplish in one of two ways. You can try one of the enhanced index funds, which for the most part deliver slightly higher returns and slightly higher risk. Or you can take a portion of your money and invest it actively. A little towards the end of this class, we'll talk about these melted philosophies where the bulk of your money might be passively invested, but a little portion might end up active. But remember again, you know, when you open up to activity, you are opening up to the risk that that activity will not pay off.

14:00 So, in summary, index funds have become a much more much bigger and much more attractive choice for many investors because you have so many more choices left. And their biggest promise remains they offer those lower costs. They don't try to beat the market. Though a subset of them try to claim that they can beat the market and offer the lower cost, be be skeptical about those promises because, you know, while they're on paper, they may they look good. In practice, they're much more much more difficult to deliver.

14:31 I hope you found this session useful and I thank you very much for listening.