Barry Ritholtz has an interesting post up citing research that indexing still beats active management. This is an important nugget of information to have in your arsenal of knowledge as you try to manage portfolios, yours or for other people.

The debate between passive and active has been around for a while and is not likely to go away but I think it overlooks something that I have tried to explore here with a few posts. Being 100% invested in a particular index will have a certain amount of growth that can be expected and some measure of volatility associated with that growth.

A mutual fund manager, hedge fund manager and in many instances an investment manager (what I do) do need to show outperformance at some point for their clients or partners or they may start to lose business.

If you are managing your own portfolio the need to beat the market becomes less significant. A 50 year old with several million saved, a high paying job he wants to keep doing and a modest lifestyle needs growth but probably not market beating growth and the volatility that might go with it.

A 60 year old with $300,000 saved probably has a much greater need to be exposed to normal market volatility because this person is more likely to need to keep up with the market.

Part of managing your own portfolio is accurately assessing what you need your portfolio to do. Being too aggressive when you have more than enough saved can have the same result as being too conservative when you haven’t saved what you need; not enough money for when you start drawing paycheck off of your savings.

There are plenty of ways to construct a portfolio to meet your specific needs that should blend together things that behave like the Yield Hog ETF is supposed to (low volatility high yield) and things that behave like Research In Motion is supposed to (high octane explosive growth potential). These are just examples I don’t own either one.

The point here is, as an individual, your portfolio needs to do something. A financial plan (not a pitch for hiring someone, you can devise one yourself but at least read up on the how to do it) can tell you what your portfolio needs to do. If you only need 5% a year you may think twice about trying to make 20% a year.

I can appreciate that a trader will not have much interest in this line of thought.


  1. ROGER,

    How about telling us about a stock or 2 BEFORE you buy it so we can all track it and maybe even go into it. I see you say you sold 2 recently for big profits which I am sure is accurate. Please enlighten us with stocks you are to buy in the next few days.

    I ask this out of respect for you, not making light of your claimed successors!!

  2. I see an inconsistent message. Investment managers have to outperform but the individual investor, if savings allow, can lag with lower volatility? Roger, my sympathy, honestly, if your high net worth clients impose upon the former on you. I’ve posted this sentiment many times here, Kudos to our host for championing the concept and goal of slow and steady. For me it raises the question, what is a good benchmark for such a tortise like portfolio? How close to the total market and how little volatility? I would not make a very good client. For total market, it would be some combination of all caps vs style/foreign vs domestic/ develped vs emergering. Can there be hard numbers to represent lag and volatility? Can our brokerages give us charts of our portfolio over time ala mutual fund charts at Ongoing feedback is important to makeing adjustments and learning from experience.

  3. I was recently pitched “separately managed stock accounts” by a well respected financial planning firm. They charge a 1% management fee plus the underlying 1% for the separately managed account. This means that they have almost a 2% drag to overcome the very low cost ETFs and Index funds I use now. Can ANY manager really expect to outperform ‘the market’ by over 2% year in and year out? If not, then why on earth would you give them your hard earned money to manage?
    Am I missing something here?
    I’ve been able to capture about 80% of market returns with an overall investment beta of less than 0.5 since I retired in 2000.
    Slow and steady with low volatility lets me sleep at night.

  4. to the 8:05 comment. I might replace inconsistent with potential cross purpose. The fix is proper communication. As in my post, the 50 year old with more than enough who uses an IM needs to be introduced to the notion of game over with some portion of the portfolio. That person then of course needs to decide if they agree.

    Like wise the person without enough needs to be told that. This lets both people make an informed decision for their own portfolio.

    We have some clients like the 50 year old with more than enough. I don;t really care whether that person beats market. Hopefully the person at my firm who deals with him as primary contact can convey what the proper goal is and hopefully that person buys in.


    Beat the market by 2% every year? Maybe not when looked at a year by year basis. While many people can;t think in these terms the value is seeing what, if any spread to the benchmarket has been put on over several years say five or ten years.

    If you compound out that way that is great and one bad year, which will come of course doesn’t mean much.

    I will say 2% is very high but that is what banks and brokerages have to charge. The broker has to get paid, his firm has to get paid and the people actually managing the account have to get paid.

  5. RinP, I can like your benchmarks for slow and steady. The half exposure to equities is impressive. The percent of mkt return is easy enough to calculate. How did you get beta? Have you consciously chosen low beta investments or does beta capture your total portfolio? At some point over time, and I don’t know where, a low beta portfolio will beat in real dollar terms a higher beta portfolio even though annualized returns are lower. IF this is sound reasoning, I wonder where the sweet spot is for beta and annual return when one is willing to lag.

  6. Anonymous asked “How did you get beta? Have you consciously chosen low beta investments or does beta capture your total portfolio?”

    I have found that you can get Beta data for almost all mutual funds and some ETFs. The problem is to make sure they are using the proper benchmark. For example, S&P500 index beta is 1.0; Fidelity Europe 1.19; Fidelity intermediate muni fund is -0.02, many REIT funds correlate with small cap value , etc.
    The Beta that I report for my portfolio is a weighted sum of the individual invstments.
    I am content to trail the overall market during a bull run if I can provide additional protection on the downside. Most retirees I know don’t want to spend their lives trading or following their investments on a daily basis so a low beta, moderate alpha approach with occasional rebalancing seems to work.

  7. In practice, it is relatively easy to beat S&P 500 index as an individual or portfolio manager. The 30% gain of foreign currencies over US dollar in the past 5 years gave international large cap stocks a 30% advantage over US large cap stocks assuming everything elase being equal.

    So you decide to beat S&P 500 by choosing international stocks. The next question is should you invest in international indices or funds?

    I believe international markets are less efficient than US large cap market. For this reason good actively managed funds have a better chance to beat his/her bench mark index.

  8. Interesting that you add the comment about traders not liking your advice. As a professional trader, I use a lot of index funds. There is a certain segment of the market where I think I can make excess return both for myself and my clients — bonds. I trade this actively for myself. If I won the lottery and retired tomorrow, I’d still trade bonds actively for myself. I don’t feel I have a competitive advantage in stocks. When investing in the equity market, I really just want to capture the long-term tendency for stock prices to rise. If I do anything other than buy index funds, I’m messing with that simple goal. So most of my personal equity investments are in index funds.

    Risk isn’t just volatility or negative return. Risk is really the chance you won’t meet your financial goals. If I believe strongly that the basic long-term appreciation of stocks will help me meet my goals, then why pay fees to someone who might help in this goal but might not???

  9. Back to the problem of the relationship between DBV, the carry-trade currency ETF, and the dollar. Theory is theory, but data are data. Plotting DBV versus FXE, the euro ETF (and dollar hedge) over the past six weeks or so, reveals what appears to be a strong (negative) correlation. Should this relationship stand up over time, it would suggest an unintended (and unwelcome) positive correlation between DBV and the dollar.

  10. Ok. So indexes “beat” the active manager.

    I’ll bet that 90% of those investors in the S&P500 over the last 6 years would like to do them over again. I bet 90% of them can not take the down 20% two yrs in a row.

    Much less ’73-’74.

    So, Ritholtz, WHO CARES?

    Most people want to make a decent return in an up market and NOT lose it in a down market. An index can not do this………it has to be actively managed.


  11. g: I really like your emperor wears no clothes view of the world, but the point you’re making… is it an index or timing argument? etf indices do a great job of capturing longer term trends and Tom G certainly is doing a fine job, so far, even if one was to use broad indices like vti, efa, and eem. But, presumbably, the payoff is from the interaction of index choices and timing. (psss…. still interested in your model). Today, I’m only 62% in equities but if I had good reason to believe that I had the odds with me, I’d be a little further out.
    re DBV..someone agrees with me, not my post, i’ve decided to use a global total return fund instead, let a pro activley manage it more than 4x per yr.

  12. The academics have shown broadly diversified buy and hold strategies that use low cost, indexed securities tend to outperform active management strategies over the long term. But g is right, most investors can’t stomach the bear markets and stay the course. These investors eventually turn to active management and timing, both tend to underperform broadly diversified B&H portfolios during bull markets (but avoid huge losses during bears).

    It’s a psychological dilemma, but here’s a thought: Split your investment portfolio in half and use a flavor of both strategies.

  13. anon:

    You make my point. We can no longer make the blanket call that “indexes beat active managers” because there is so much we can do with the ETFS. You own situation now shows this. Is a guy who “Manages Indexes” an active manager or an indexer. See?

    Most “active managers” use indexes. You are right, the timing of it all will add alpha and lower beta.


  14. Agreed that indexing looks great in an upmarket and not so great in a down market… I am an individual investor who had a minor inheritance I had to manage a few years ago and had to educate myself quickly… I started with ETFs as I educated myself but it didnt take that long to learn the better deep value managers and I now have a simple five fund 100% active portfolio that has beat the SP significantly over the past five years while holding 25% bonds and 25% cash… those sort of returns I will live with and I dont mind it when I am falling a bit short when the big caps and tech have a surge… all I care about are 5-10 year numbers and managers who lose less rather than make more… the outperformance takes care of itself…

    Andrew W
    San Francisco

  15. George,

    We might be getting tripped up on terms. What if we call the two camps “passive allocators” and “active allocators”?

    Passive allocators can use indexed products, but their trading is minimal – limited to annual re-balancing and slow shifts away from equities and into fixed income instruments as their clients get older or meet their savings objectives. They are the buy and hold crowd.

    Active allocators also use indexed products, but employ sector/theme rotation strategies or market timing techniques to reduce risk. Portfolio turnover is higher, commissions are higher, and more work is required…BUT a good strategy and execution can reduce risk significantly.


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