"Active and Passive Investing
As you can see, the manger of an index fund doesn't have much to do. For this reason we call indexing "passive investing". The alternative is, not surprisingly, "active investing". Active investment managers don't want to buy all the stocks in a market, only the ones that they consider attractive. And since attractiveness changes as information and market prices change, this involves relatively frequent buying and selling -- hence the term "active".
Let's think a bit about the performance of active and passive strategies. Assume that you in this room constitute the entire universe of investors in the French stock market. About a fourth of you will be passive indexed investors, while the rest will be active investors. Collectively you hold all the stock on the French market. Now let's pick a time period -- say a year. And let's say the market as a whole returned 10.0% in that year. Before costs, what did each passive investor get? Exactly 10.0%. Obviously, before costs that average passively managed Euro returned exactly 10.0%.
What about the active investors? One might have made 15.1%, another 3.4%, yet another -23.0%, and so on. But what did the average actively managed Euro invested in the French stock market return before costs? The answer has to be exactly 10.0%. Why? Because the passive part returned 10.0% and the total market returned 10.0%. So the active part had to return the same.
We conclude then that in the French stock market the average actively managed Euro must have the same return before costs as the average passively managed Euro.
But before-cost returns aren't what matters. You don't eat before-cost returns. What you eat depends on returns after costs and, for that matter, after taxes. So let's consider costs and taxes.
The people running index funds are dull but they are cheap. They only need to know the names of securities in a market and the number of shares outstanding. You would not want to be stuck at a cocktail party with one of them. But their costs are minimal. Depending on the market replicated, the cost of managing an index fund should be somewhere between 0.15% and 0.50%, or 15 to 50 "basis points", using financial jargon.
Active managers are very different. They do research on companies, try to untangle the web that corporate officers and accountants sometimes weave, try to predict acceptance of future products, and so on. Their security analysts and portfolio managers are smart, well educated, and fascinating conversationalists at cocktail parties or anywhere else. But they and their activities are expensive. Their costs are likely to be at least 1.0% (100 basis points) higher than those of passive managers in the same markets.
Worse yet, the very activity that these managers undertake adds to costs. Brokers have to eat too, and many active stock funds sell stocks within 6 to 12 months after they buy them.
This is not all. Taxable investors have yet another reason to worry about active management. It generates realized capital gains far more frequently than does passive management. This requires the payment of taxes that could otherwise be either deferred or, in some cases, avoided entirely.
The bottom line is that after costs, the average actively managed Euro (or dollar, or yen) must underperform the average passively managed Euro (or dollar, or yen) in a market. This is simple arithmetic. And this is the basis for the assertion that indexed investing provides a way for you to beat the average investor in a selected market.
How big is the advantage for this approach? It depends on the index fund and the expenses of the active managers. "
