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Dr James:
What is up, dennis? Who invest nation? We are returning back here again another day with familiar face, luke Hurley, and we’re here today to talk about active and passive funds, which are super relevant to everybody’s investment portfolio, although not everybody knows what they are. Luke, how are you, my friend? Very well, james. Thank you. Very well, vunderbar. So we’re going to delve into some delicious juicy stuff today, which is active and passive investing. I suppose we might start out by just defining what those terms mean.
Luke:
Yeah, sure, so a fund is a vehicle Actually, actually sorry, sorry.
Dr James:
Let me just be super clear on that definition not active and passive investing, specifically active and passive funds. Right, that’s what we’re here to talk about. It’s slightly different?
Luke:
Yeah, exactly. So a fund for those that aren’t sure is a vehicle that you can use to pull your money with other investors rather than investing directly into different securities. And active funds are those where an individual known as a fund manager tries to use his or her skill to pick the best shares or other asset classes to make the best return possible for the investors in their fund. So what they’re trying to do as an active manager is gain an advantage by picking the shares of companies that they think are going to perform better than the market that they’re focusing on. So active funds usually compare themselves against relevant benchmarks or an index. An index is a way of measuring the performance or price movement of just about anything In the financial world. Indices are created to track things like different companies from different different regions. For example, the FTSE 100 is an index that tracks the biggest 100 companies that are registered in the UK. Other examples would be the S&P 500 or the Dow Jones there’s literally thousands. And, by contrast, a passive fund, where an active fund is trying to beat those benchmarks, a passive fund is really just trying to track the performance of the index as a whole.
Dr James:
Absolutely 100%, and a really good example of an index just to really crystallize that for people would be the S&P 500. And the thing about it is right. With these indexes, they’re kind of somewhat arbitrary as to their constitution, as to what what they’re composed of, but the really cool thing about them is, because they’ve been around for so long, they’re the best we have in terms of us being able to have something to measure performance against, have something to measure performance of other funds against, and what I mean by that is we just have to have a benchmark somewhere. There’s nothing magic about an index. It’s just that it’s some data and a yard stick that we can use to compare to other investments.
Luke:
Yeah, and for me, the ultimate benchmark is a global index fund, in that it is really just a combination of all the companies around the world that you can buy shares in, and so if you look at the performance of a global index fund, what you’re really looking at is the performance of global capitalism, and so for me, that’s the ultimate benchmark. Bunderbar.
Dr James:
Cool. So there’s obviously two schools of thoughts. There’s two schools of thought whenever it comes to funds. Some people are in the active camp and they’re like, yeah, let’s go ahead, let’s invest in something which we believe has the potential to beat the market. Or there’s people who are just accept. There’s people who are more along the line, who think more along the lines of but we accept, this index is done well. Therefore, all we want to do is continuously buy something which we know is performed well historically and then therefore benefit from the consistent appreciation of that index as displayed by its historical data. There’s two real schools of thought on that one. Isn’t there really?
Luke:
Yeah, and some people get very, very passionate about this subject and it’s often pitched that you have to be in one camp or the other, like there’s two warring churches that you have to pick in affiliation. I’m not somebody that falls into that camp. I think that they both have a place in an investment portfolio for reasons that will go into. Although I would say that if I had to choose, I probably would choose the evidence based investing approach, ie passive funds. In terms of comparing them or breaking down the argument, I think the first thing we should start with is performance. So the argument goes well, it’s not really an argument. There is a large body of evidence that displays the inability of many active fund managers to deliver alpha, which is basically performance above an appropriate risk adjusted benchmark. Beating the market is over. The long term is difficult for anyone, including skilled professionals, and lots of people rightly have a real issue with that. When you look at the data and you see that a lot of these active fund managers that are charging quite a premium for their services aren’t actually beating the market as a whole, you can see why there’s a lot of people that prefer the passive route and actually some research suggests that the number of successful long term managers is no more than you would expect by chance. That is worrying, isn’t it when you’re building a portfolio? I think the other thing to point out is that, whilst there are some active fund managers that will perform well in the short term, the success is rarely sustained over longer time periods. And as you look at the data, the longer you stretch out the time periods, the more sort of damning the numbers are in terms of active fund manager outperformance.
Dr James:
There we are 100%, and the important thing to mention is that sometimes, with active funds, I feel like people are drawn towards them because they seem sexier or there’s more chance of them outpacing the market, and oftentimes people will say, oh, but look, over the last five years, my fund’s done better than the S&P and blah, blah, blah. Really, what we’re talking about is really long term timeframes. You can only really make that comparison maybe on a timeframe 10, 15, 20 years, something like that. Yeah, so on those timeframes, as you say, the data is pretty damning. It’s something like 97% of the time active funds fail to beat a risk. Adjusted benchmark.
Luke:
And there’s good reason is it’s incredibly competitive in terms of the marketplace and there are lots of very clever people with large teams of researchers and analysts that they get it wrong and they’re actually unable to beat the market as a whole. If you look at the data over 10 years and it depends on which region you’re looking at but whether they be UK funds, US funds, so on and so forth, figures aren’t great. Uk funds, as an example, around about 75% over a 10 year period will fail to beat their benchmark. All of this data is available online with a simple search. It’s not great, the numbers aren’t great and the problem with that is obviously. Human nature drives us to believe that we can defy probabilities and be the lucky winners, and I think many investors are constantly looking for an edge, so they’re drawn to the idea that they can pick this winning active fund manager that’s going to propel them to great wealth, when actually the evidence suggests that over long time periods there’s actually even less of a chance of a fund surviving, let alone outperforming. Lots of them get rolled up or merged with other funds and it gets quite difficult to follow and the marketing companies of these big investment houses again if a fund isn’t doing particularly well, it often finds itself getting wound up and a new shiny fund gets launched in its place which doesn’t have the negative performance history. So it’s a difficult arena, so to speak.
Dr James:
I know that the saying it’s a marathon, not a sprint gets thrown around a lot, but it’s just so apt in this situation and people have to understand just what a sprint looks like whenever it comes to their long term investing strategy. A sprint is like two, three years, okay, so that’s literally what you would call a sprint relative to how long you’ll typically invest for a pension, or you’ll invest for financial freedom, or you’ll invest with your ISA or your SIP, or at least if you’re using funds anyway in the most conventional approach. So really, whenever we’re making these comparisons and people are maybe a little bit gleeful that they’re active fund as I’ve performed the market, just note that that’s what we’re calling a sprint at this point. Right, and really, really, really, really really. We can only make those comparisons over much longer time frames and when we get to that level, the data is just so much in the favor of passive funds. There’s a few things we’ll get into in just a minute, but I just want to take a quick, tangent, I suppose, or side quest and just ask you in your experience as a financial advisor naturally people would come to you who had invested their own money or maybe received advice from another professional? How often would they have a portfolio composed of active funds? Very often yeah, all the time.
Luke:
Really Wow. Yeah, lots of DIY investors will be drawn towards the active approach. In my experience, my default for most people is always to go down the passive route, unless they had a strong belief in active funds for other reasons that we’ll go on to look at. But no, lots of DIY investors really do get drawn towards active fund managers.
Dr James:
That is really, really, really interesting, because here’s the thing. We’re not saying necessarily that they’re a bad idea per se, but what we are saying is that the odds are certainly stacked against you, particularly if your whole portfolio is composed often.
Luke:
Yeah, yeah. I guess on the flip side we need to mention that, from the performance side of things, clearly passive investors they’re only ever going to get the average market return less the cost of that fund. So many would argue that the aim, or having the aim, of capturing the market returns is a very worthwhile objective, given all the things that we’re going to cover. But it is worth pointing out that you will only ever get that market return. You can’t go beyond that.
Dr James:
Absolutely so.
Luke:
There’s not really there’s no scope to outpace the market, but even just keeping abreast of the market is enough to beat most active funds, and it’s certainly important to explain that, just as we have done Historic returns that have been available just by being in those markets, like if you had a global index fund and you just tracked global growth over the last 20, 30 years, you would have made a significant amount of money. So it is certainly a worthwhile objective, but it is. You know, you are. You are capped, so to speak, from a performance perspective.
Dr James:
Cool, you mentioned fees just then. Let’s develop that and compare the notion of fees between active funds and passive funds, because this is another big potential sticking point.
Luke:
Yeah, and that’s definitely the second one to cover is typically passive funds are going to have lower cost than active funds. It’s as simple as that across the board, because with an active fund you’re paying for the, the fund manager and their team and the extra work that goes involved in terms of trying to pick those, those investments that are going to outperform the rest of the market. So as a result, you pay higher fees. There has generally been a downward pressure on fees across the board and no doubt the growth in passive funds has really helped with that. There are quite a few funds out there still a lot of the time they’re old pension funds I used to see it most often but they’re what we would call closet tracker funds, which which basically means they’re doing nothing really more than tracking a market, but they’re charging quite high active fund management fees. So they might be charging circa 1.5% as a fund management fee when really you’d be better off buying a low cost index fund for significantly less. You can get index funds for anywhere between sort of 0.0,. You can get some as low as 0.056%. If you go to Vanguard, you’d pick up an index fund for about 0.2, 0.25% as an example, if you go to some ETFs, then you’ll get in cheaper than that. So it’s a big difference between some active funds that are charging over 1% and some some passive funds that are about 0.1%.
Dr James:
Well, this is something I experienced at the start of my investing career, I suppose, if you want to call it that. I literally didn’t have a yardstick through which to compare what are high fees versus what are low fees. I always looked at the fees and think 1%, that’s pretty good, I can manage that. But what is really helpful about what you’ve just said is now people have a frame of reference through which to compare and then ascertain the performance of their own fund, which is super duper, super useful.
Luke:
Fees, fees fees, fees, fees. You have got cheaters to jump in that I would mention. On fees, it depends on what the fund is doing. For example, funds that are going to invest in emerging markets will typically be more expensive, and you should expect that because there are higher costs involved in terms of the work that goes into them. So there is even within those two within the passive world and within the active world there’s a sliding scale of what you should expect to pay for what the fund manager is doing. But if you’re just looking at, for example, a UK fund or a US fund, paying 1.5% for active management is pretty high. There are some really great investment trusts out there that are actively managed where the fees are significantly less than that. You can get active funds that are 0.6% 0.7% that have great track records. So it’s just about being aware of what’s expensive for what the fund manager is actually delivering.
Dr James:
Yeah, 100%. And yeah, just to make that super clear, I was referencing passive tracker funds just then. So yeah, you’re actually right, there’s caveats to it. It depends on the nature of the fund, doesn’t it specifically for tracker funds? I didn’t know any better. I was going for the ones that were like looking 1% and stuff like that. But what is really cool is that when you know that you’re looking for a passive style of investing, you know that you’re looking for tracker funds. Really not 0.2, not 0.3, not 0.4, in my experience, is a really good round. Em4. Whenever it comes to fees, let’s move on to. This is okay. Selection right, and this is where we’ve got to be really careful because, obviously we can’t give financial advice, but we can give some high level information whenever it comes to fund selection.
Luke:
So selection really trying to select active fund managers adds an extra layer of risk to your investment journey because obviously the great fear is that you’ve picked the wrong one, you’ve backed the wrong horse. So if you compare that to investing in passives, you remove that risk entirely. You’re not worried about backing which horse you’re backing, and that, for me, is one of the key arguments in favor of passives. It removes that whole anxiety, if you like that you’ve gone into the wrong fund, you’ve backed the wrong fund manager and you’re constantly checking your portfolio to see how they’re doing against their peers and everything else. I would also say that lots of people select their funds based on what you said earlier previous short-term performance. So you see, when you look at the data, that all of the money tends to flow to active funds following a period of strong performance. So a fund does well, the money flows into that fund. It then possibly reverts to the mean towels off and then the money comes back out again, and that’s generally the pattern and that’s human nature in terms of how investors operate.
Dr James:
Absolutely so. Whenever it comes to deciding are we going to go down the route of having a passive fund or are we going to go down a route of an active fund. I remember at the very start of this podcast I said active versus passive investment and then I was really quick to clarify specifically. We’re talking about active and passive funds, but it just so happens that when you pick active funds, you’re probably more likely to have to actually do some active investing as well, because you have to be conscious about where your money is and you have to think about dipping in and out and all these extra layers of decision making based on individual traits of the fund, the manager, etc. Etc. And you know what that actually requires. So much headspace. Like you have to think about that a lot. Speaking from personal experience, I was just like everybody else whenever I dived in. At the very beginning I thought yeah. I fancy myself I can beat the market, and then you realize with time just what that process looks like and how much you have to think about it, and really, the ultra stacked against you. So chance saw you’re going to spend more time thinking about it and get less returns, and I was just like, whoa, okay, the passive way is the way for me. Passive funds are the way for me, because it just eliminates all that additional thinking and it also means that I’ve got what like 50, 60 years, 70 years of data to show that whatever it is that I’m investing in that is tied to a. Well, the index, the index that it’s tied to, is 67 years of data. Yeah, then I’m thinking to myself, wow, okay, well, if this fails, then what it’s going to mean is the economy of America fails or the flipping world’s economy fails. And you know what, whenever you’re making investments decisions, to have that level of robustness behind your, your assets, to have that level of data behind your assets, just gives you so much additional free headspace to think about other stuff to think about things like earning more money, if that’s important to you, because that’s actually realistically. One of the ways that you can make your bank balance go up even faster is if you have the time to dedicate thinking about what you can do day in, day out to earn a little more, if that’s important to you, of course.
Luke:
Yeah, I really agree, and I mean ultimately the I mean I used to say it a lot there is no way of identifying future successful managers. There’s no robust process that you know, that you can quantify, that you can follow to be guaranteed that you’re going to pick those active money managers ahead of their. You know, their short term performance taking off and that’s why most people, when they’re doing their research on active funds, all they’ve got to go by, as far as they’re concerned, is the short term track record. So they will look at what have they done over the last one year or three years or five years, when, actually, when you think about it logically, if a fund has has delivered a really strong return, then there’s a good chance that it’s due a slight correction and it will revert to the main. So, yeah, very difficult. The selection process very difficult.
Dr James:
The passive option removes that headache entirely 100% top stuff particularly if you’re a dentist, because you’ve got barely any head space as it is.
Luke:
Yeah, and that leads to the fourth point, which was about maintenance, and that that really does tie in. You know how much time do you have if you’re working flat out as a dentist? How much time do you have to to commit to this, to do it properly? If you’re choosing the active, the active route, it’s, it’s, you know, it’s. For me, a portfolio, a good long term portfolio, should be low maintenance and low anxiety and where, even if you, if you, if you do select active funds in an ideal world, you then you set and forget, in the same way that you would with a with a passive portfolio. But the reality of that is lots of people, don’t they, fall into the trap of constantly monitoring their portfolio for short term performance and and questioning whether they they’ve picked the right funds. I would also say we need to mention that with passive funds, they do have that sort of self cleansing mechanism in that underperforming companies are removed from the index and replaced with with new ones. So there is that constant process which which works in in the investors favor. They eliminate the fear of losing all your money as well, because the, because the fund is so well diversified, if you’re buying the market, you don’t have to worry that you’re. You’re choosing fund managers as as bought the wrong underlying shareholdings and since you own, you’re in the lot ultimately. So a globally index fund could be spread over 8,000 different shareholdings. You’ve you’ve diversified, you’ve mitigated those specific risks that we talked about in our last podcast, because you’ve got the benefit of having your money so well spread across different different companies in in different countries.
Dr James:
Absolutely. The self-cleansing thing is actually a really good analogy that I’d yet to come across until you said it just then, and it is worth mentioning that. Let’s use the S&P as an example again, and maybe you’ll know this stack better than me, but there’s something crazy like six companies have been responsible for 60% of the growth in the last 10 years, and it’s something along the lines of like Tesla, apple, facebook, something like that. Right? So by having exposed the fact that those companies are skyrocketing, which will mean, by default, you have exposure to them because they’ll just appear in your fund one day, whereas having the foresight to select it as a fund manager it’s pretty rare. You know what will chances are. What will happen is they’ll jump on the bandwagon too late.
Luke:
Yeah, yeah. And the risk side lots of people worry about their portfolios in terms of capital loss and, as we mentioned last time, they confuse short-term volatility with permanent capital loss. Well, if you’re in a global index fund and your money’s spread across 8,000 different companies, unless all of those companies simultaneously collapse, your portfolio is not going to drop to zero, and if it does, then something extraordinary has happened and anything else that you could do with your money is probably also collapsed as well. So for me, that’s a big one. It’s that diversification packaged up, low anxiety, low maintenance, set and forget approach to long-term investing that is attractive.
Dr James:
Cool. So come towards the end of this podcast and just before we wrap up, I had a quick question. So I know that you said at the very start that you don’t necessarily sit in one camp or the other, and I actually agree with you. But for two chaps who think like that, we spend a lot of time talking about the merits of passive funds. Well, in your opinion, do you think there’s a good justification for an active fund in someone’s portfolio?
Luke:
So I mean personally. I have core funds in my portfolio which are passive funds, and then I have some satellite funds that I add to the portfolio, just one because I find it interesting it’s scratching the itch, if you like and two because there are some really great active funds out there. You can’t escape that fact. One of the wealthiest men in the world, warren Buffett, is an active fund manager ultimately is an active manager. So it’s adding some really great funds with long trap records and then buying them and holding on to them and intending to hold on to them for a very long time. What tends to happen is people buy their active funds and they’re looking to whether they should move after a year. The reality is, if you’ve backed an active fund, you should be looking to back it for the next 10 years In. That’s just my opinion. So the active funds that I do have in my portfolio are ones that I have no intention of changing based on short term performance. They’re funds that I buy into unless the manager changes. I will caveat that but they’re fund managers that I’ve bought into in terms of their philosophy and their approach. They’ve got consistent long term track records and that, for me, is attractive. So just saying something, I think what we’ve said is incredibly difficult for most active funds to beat the market, but that’s not to say that some active funds don’t do it and don’t do it consistently. I just think it’s about having commitment to those funds and really backing them.
Dr James:
Talk stuff, and, certainly from what you said earlier, it’s kind of like a pendulum, isn’t it? We want the pendulum to be somewhere in between the two extremes, and most people are way over here when it comes to being overexposed to active funds, right?
Luke:
Yeah, and also I said earlier that my default for lots of people has always been to certainly start with passive funds, and for me that’s just a simple question of probabilities. So passive investing is all about losing the fewest points to have the greatest probability of success. So if you’re somebody that just wants to set up an investment portfolio, be able to set and forget, benefit from long term compound growth, then a portfolio of passive funds is great, or even just one passive fund is a great way of doing that. The mathematical odds are in your favor. If you go down the active route, then those odds change slightly, but I just know human nature, that people will still be drawn to it. So one way of dealing with that is, as I’ve just outlined, is to have a mix, a blend of the two. If you’re going to have active funds there, you need to do the work and you need to really put in the time to work out which fund manages your backing and why, and not base those decisions just off one, three or five years of performance data. And then the final thing actually that I would add is the argument that all of this is something of a sideshow. So I would say choose the path that you think is going to be easiest for you to stick to. And then and the reason why it’s a side show is really that 80 to 90% of your lifetime returns as an investor are going to be a tribute you know are going to stem from planning, asset location and your behavior as a human being, and the other 10 to 20% may or may not come from portfolio management in terms of the underlying funds that you selected. So lots of people put all of their attention and focus on the active versus passive debate and picking funds, when actually the vast bulk of your returns will come from what you do in the planning stage, how you construct that portfolio in terms of the asset classes that you use, and then how you react when your portfolio goes through market cycle. So, yeah, it’s worth putting some time and thought into how you know what you want your journey to look like and then really stick to it.
Dr James:
Cool, and I can actually rhyme off some stats on this off the top of my head, because I saw a graph that displayed this very nicely and very visually the other day. So let’s say we have an investment portfolio that appreciates at a rate of 10% per annum. So let’s say that someone puts 10,000 pounds into that portfolio and they leave it, they don’t touch it, they don’t do anything for 40 years. So 10% is in and around what’s achievable in the American stock market. It’s going to be less fees, depending on which fund you choose. But let’s use that as a benchmark or as an approximate of something that’s representative and achievable. So 10% returns 10,000 pounds in a portfolio that’s left for 40 years will appreciate to 450,000 pounds, and that’s if you don’t touch it Now. Naturally, inflation is going to be a factor in there as well. Let’s use that to compare what happens when you have, let’s say, 1% fees in your portfolio or certainly 1% less rate of appreciation. And that can be because there’s fees or it can be because there’s compromised returns because we’re using an active fund which is not appreciating at the same rate as its passive benchmark. So if it’s appreciating a rate of 9% a year, that same 10,000 pounds will be worth 300 K after 40 years. So you’ve literally lost 1% over that period of time. Cost you Let me do the math here. If it costs you one third of your entire portfolio, that’s crazy. So that’s the difference between select and a passive option and an active option. If we reduce that figure even still to 8%, then it’s 260 K off the top of my head, which is almost half In fact. Let me just do the math there really quickly. Yeah, it is, it’s almost half. So these one or 2% differences make a massive, massive, massive difference on the icon of your portfolio over those time frames and I didn’t just pull 40 out of the air Most people start their career 25-ish, especially if you’re a dentist, and lots will be working until they’re 65 or 60, which is around about 40 years. So you can really see how this stuff adds up.
Luke:
Yeah.
Dr James:
Cool Top stuff. Right, we’re going to draw a line under proceedings today, luke, anything that you’d like to say to wrap up?
Luke:
No, enjoy today For me. As I said, don’t draw too hard on this stuff because ultimately you’re long-term outcome is going to be driven by other factors. But know your strategy, know your approach and stick to it. Boom.
Dr James:
Guys, for those of you listening who really enjoyed this podcast, luke and I have created something special, which is the Dentist who Invest Academy, which will teach you everything that we talked about in today’s podcast and way more, and it will also teach you how to apply it into your own life and your own investment portfolio. You can find the link for Dentist who Invest Academy in the podcast description. We have got a special offer on at the minute. If you hit apply coupon whenever you’re on the landing page and you type in DWI20, you can get a discount of 20% of the investment for the academy. This discount applies until August 7th that’s Monday, the 7th of August, and therefore what that would mean is you have the whole of the weekend to avail of this opportunity. We’re looking forward to teaching you so much more on there. Okay, talk stuff. We’re going to wrap up now. Amazing podcast. Thank you so much. Look for your time. I’m looking forward to the next one. I’ll see you soon.
Luke:
Thank you.