Now, before the passive investing diehards defenders roll in, I’d like to say that I passively invest upfront in this article.
I’m one of you. We’re on the same team. I buy Irish-domiciled Index Funds – specifically CSPX – and intend them to hold them for the long run. I also hold some 20% of my portfolio in the much scorned STI-ETF.
And I must say, I get the appeal.
Passive index investing through Indexed Mutual Funds or Exchange Traded Funds have been lauded as the Holy Grail of retail investing.
Low cost, market returns, and pretty much what you see is what you get transparency. The most common index used to highlight the magnificence of this strategy is usually the S&P 500. A broad based market cap equity index that tracks the biggest 500 companies listed in the US stock exchange.
So all good so far, why should anyone consider anything otherwise?
Well, here are a few things we think passive index investors should just take note of when embarking on this strategy.
I’m not saying it’s bad by all means, I still think it’s a wonderful simple strategy, but investors need to know what they’re getting themselves into. Due diligence is in short supply these days.
And we’re here to offer a little of it.
IMPORTANT: The S&P 500 is the exception, not the norm
It is likely that most of what you’ve read or heard about passive investing has been an understanding of the US market.
And while it’s a great market that represents 50% of the world’s equity market, with innovative global companies that earn their business globally and not just domestically, it is not usually the same truth for markets outside of the US.
Without picking and choosing to suit the narrative, let’s list the indices for the major developing countries outside of the US, plus one global index to wrap it up. In order of market cap, we have:
| Market and Index | Returns since 6 March 2009 |
| United States – S&P 500 | 323% |
| Japan – Nikkei 225 | 219% |
| UK – FTSE 100 | 82% |
| Canada – TSX 60 | 104% |
| France – CAC 40 | 89% |
| Germany – DAX 30 | 246% |
| Switzerland – SMI 20 | 135% |
| Australia – ASX 50 | 84% |
| Developed Global – MSCI World | 131% |
I have chosen to highlight the absolute market low after the Great Financial Crisis of 08/09. While most global equities are positively correlated (they react together) it isn’t always going to be the same degree of movements.
With the US markets making a staggering 323% since the crash, other markets barely made a quarter of that. To put things into context, that’s an annualised 12.9% for the US stocks while it was only 81.68% or 5.3% annualized for the UK index.
And again, this is after investing at rock bottom prices post-GFC. You had to be a god to time the market exactly at that point and go all-In.
Japan, for example, did great since 09 – but look back before the turn of the century whereby it experienced two lost decades.
Same with France, UK, Switzerland from the turn of the century. Most of them made barely anything if you bought in 2000 and sold today or even pre-COVID level highs.
This tells us that America’s economy and the resilience of the stock market is truly the exception, not the norm.
To quote Warren Buffet: Never bet against America.
There is no such thing as ‘buying the index’
One thing we need to discuss first is that you can’t ‘buy the index’. This is the same for the US market and every other market.
Index Investing is buying a fund that tracks or replicates the index.
What you get is Index – Expense – Tracking Error = Return (not including brokerage fees and taxes).
In the US, the cost and tracking error (how far the fund differs from the actual index) is so miniscule that even after fund level fees, you’re getting pretty much market returns. That’s to be expected. This was the country that invented passive investing, they’ve years to perfect the system.
But is this the same elsewhere?
Let’s look at 3 areas.
Asia Excluding Japan
Benchmark – MSCI AC Asia ex Japan Index
Index Fund – iShares Core MSCI AC Asia ex Japan Index ETF (3010)
Total Expense Ratio – 0.28% p.a
Due to fees and tracking error, the index fund underperformed the benchmark by 0.4% p.a for 5 years.
Active Managed Fund – Schroder Asian Growth
Total Expense Ratio – 1.38%
The actively managed fund have outperformed the benchmark by 3.6% p.a for 5 years and outperformed the index fund by 4% p.a for 5 years even after accounting for fund fees.
Europe
Benchmark – MSCI Europe
Index Fund – iShares Core MSCI Europe UCITS ETF EUR (IQQY)
Total Expense Ratio – 0.12% p.a
Due to fees and tracking error, the index fund actually outperformed the benchmark by 0.12% p.a for 5 years. Weird.
Active Managed Fund – Fidelity Funds European Dynamic Growth Fund
Total Expense Ratio – 1.9% p.a
The actively managed fund after fund level fees, outperformed the benchmark by 8.6% p.a for 5 years and outperformed the index fund by 8.46% p.a for 5 years.
Emerging Market
Benchmark – MSCI Emerging Market
Index Fund – iShares MSCI Emerging Markets UCITS ETF (Dist) (IQQE)
Total Expense Ratio – 0.18% p.a
Due to fees and tracking error, the index fund underperformed the benchmark by 0.63% p.a for 5 years.
Active Managed Fund – JPMorgan Funds Emerging Markets Opportunities Fund
Total Expense Ratio – 1.8% p.a
The actively managed fund after fund level fees, outperformed the benchmark by 1.3% p.a for 5 years and outperformed the index fund by 1.8% p.a for 5 years.
As you can see, for markets outside of the US, it is possible to find huge outperformance in actively managed funds even after fund fees.
Why is this so?
This is mainly because these markets are less efficient than the ones in the US.
In the US, it would be very rare to find actively managed fund managers that benchmark against the S&P 500 to consistently beat the index. But for other indices, and other index funds outside of the US, it is more common and the outperformance can be massive.
However, this may not be a reality in the next few decades, markets can be more efficient over time, and active fund managers may lose their edge. But for the time being, even charging 10x the fees, you still see consistent outperformance.
Long Period Of Stagnant Returns
I’m going to bring you back to the S&P 500 and show you this chart.
This is the best and worst chart that plots your return over periods of time.
The worst 20-year period since 1926 (94 years ago) for investors was from September 1929 to September 1949. Just a 1.89% annualized return following the great depression for a full 20 year period.
Imagine starting your investment journey at 30 only to find out at 50, your investment earned as much as the Singapore Savings Bonds. You didn’t even beat inflation.
And if you didn’t hold for 20 years, but held for 10 or 15 years instead, you’d instead have lost money.
On the flip side, if you invested in April 1980 and sold after Y2K before the dot com bubble burst, you would have made a whopping 18.26% p.a. Warren Buffet level of good stuff.
I can already tell some of you may be saying that it’s not fair to include periods of The Great Depression so let me show you how it is ignoring that outlier.
To me, this is a more damning statistic.
The best period of 20 years since 1935 remains investing in 1980 and selling in 2000, but that is then followed with the worst 20 year return of investing in April 2000 and selling 2 months ago which would have given you 4.79% annualised.
That’s the equivalent of beating CPF while taking the full risk of a 100% equity market.
What you need to understand is this: Yes, the S&P 500 always goes up in the long term.
But sometimes, this might be far longer than you expect. ‘Long’ might be 5 years, 10 years, 20 years.
Conclusion
In the age of the internet and extreme confirmation bias, it’s easier than ever to shut your mind out to critics. But it’s always important to seek out information that you find uncomfortable to examine your potential blind spots.
As passive investors, this means acknowledging this ‘bulletproof’ strategy has some weaknesses – much like everything else, really.
This is not about dissuading you from passively investing, but rather to ask yourself – with this new knowledge, how you can confront the potential problems that arise?
Off the top of my head, I can think of a few:
- Invest passively in the US market, and invest actively (or engage active funds) outside the US the market
- Slowly reduce exposure to the Index as you approach retirement
- Diversify across asset classes (property, crypto, etc etc etc) so you can outlast long periods of market stagnation
Our take? Understand the risks, make the moves you need to make.
And then hope for the best – that is the best we can do.
Good read, I am also a fan of passive investing with ETFs.
Just to clarify, are the stated annualised returns inclusive of dividends?
If I’m not wrong ETF gives you dividends. But Active Managed Funds may not.
Have you included dividends when comparing both funds?
Active managed funds also pays out dividends. Not all, depending on the type of funds. Dividend vs Growth
Fantastic article. What data sources do you use?
The part on fees is an important point that all investors need to understand! Passive investors will always earn slightly less than their market benchmark, but actually so will most active investors! Active investors incur greater fees and have greater chance of having tracking error, so ON AVERAGE they should underperform their index by even more than passive investors, which is what all research papers show.
You can always find one or two funds that outperformed after fees for 5 years, whichever time period or market you choose. But how much of the outperformance is due to luck and how much of it was because of investor skill? Its too early to say that active beats passive by finding just 1 fund that beats the benchmark after just 5 years. Maybe if the fund beat the benchmark consistently after 20 years, you can say with some certainty it was because of skill instead of luck. But how do you find that great fund BEFORE it outperforms? Active funds as a whole always underperform their benchmark.
Active CAN definitely beat passive, but what investors should remember is that passive has always been and will always be EXPECTED to beat active. This is what the data and economic theory tells us.
Passive investing is for investors who does not want to spend much time in the market nor have the skills to stock pick. This strategy suits them best and delivers a decent return. Active invest who puts in more time & effort and knows how to pick good stocks and applies different strategies. They also take on a greater risk if their plan goes wrong.
End of the day, I assume that there is no free lunch in this world. The seed you sow today will determine what you get tomorrow.
STI has the lowest returns for the past ten years.