6. Passive Agressive

The concept of passive management is counterintuitive to many investors. The rationale behind indexing stems from five concepts of financial economics:

• In the long term, the average investor will have an average before-costs performance equal to the market average. After-costs, the average passive investor will still track the index; the average investor in actively-managed funds will have below-market returns, on average. Like Boggle likes to say, this is arithmetic - you can't argue with it!
• The efficient-market hypothesis, which postulates that equilibrium market prices fully reflect all available information, or to the extent there is some information not reflected, there is nothing that can be done to exploit that fact. To put it another way, in order to pick a "winner stock", it's not enough to pick up a winning company: you need to find a company who's going to success more than the market expects it to succeed. 
• The principal-agent problem: an investor (the principal) who allocates money to a portfolio manager (the agent) must properly give incentives to the manager to run the portfolio in accordance with the investor's risk/return appetite, and must monitor the manager's performance. The way mutual funds are managed today, there's little incentive for long-term performance. If the fund fails, the company will just close it and open a new one. It's always more fun to play with other people's money, but in this case the money is ours. 
• The local elasticity of the market makes stable strategies (such as indexing) more favorable. 
• The capital asset pricing model (CAPM) and related portfolio separation theorems, which imply that, in equilibrium, all investors will hold a mixture of the market portfolio and a riskless asset. That is, under suitable conditions, a fund indexed to "the market" is the only fund investors need.

This is all high talk, and I'll freely admit I don't understand all of it. But at the end of the day, the main reason index funds makes sense to investors is because they beat the majority of actively managed accounts. Consider for instance this research from the Vanguard group:

• Over 10 years, the S&P index has beaten more than three-quarters of all actively-managed funds
• Over 20 years, the S&P index has beaten more than 80% of all actively-managed funds
• Read it again: Over 20 years, the S&P index has beaten more than 80% of all actively-managed funds!

It turns out that the most aggressive investor is the one who sits and does nothing. Who would have known?

Next week, on why Indexing is bad for the economy.