How investors are squandering the benefits of passive funds

Which single individual has proved most significant for private investors over the last 50 years?

The name Warren Buffett always springs to mind when you talk about private investors. Buffett has inspired more investment columns than any other individual, and has made plenty of small investors rich – as long as you were lucky enough to buy into his Berkshire Hathaway vehicle at the right time.

But there’s one elderly American gent who has made a far greater impact than Buffett.

In fact, Buffett said so himself at his latest investment shindig.

We’re talking, of course, about Vanguard founder Jack Bogle.

The man who saved us all billions

At the weekend, Warren Buffett and his partner-in-crime, Charlie Munger, held forth at their annual general meeting – also known as “Woodstock for capitalists”.

Buffett dispensed his usual folksy wisdom and generated the usual outpouring of rapturous column inches, supplemented by the now equally obligatory cynical takes on his views and legend status.

My own view on Buffett and Munger is that they’re a fantastic source of investment wisdom and impressive advocates of clear thinking. Just don’t take them too seriously – no human being can live up to the sheer levels of adulation and the cultish following that they generate.

Put in stockmarket terms, they’re like a high-quality company that’s trading on an extremely high multiple. They’re good – but everyone knows it, and they’re priced accordingly.

Anyway, over the weekend, Buffett took some time to praise Jack Bogle, who founded Vanguard, the index fund pioneer. Bogle has “probably done more for the average investor than any man in the country”, said Buffett.

Bogle created the world’s first widely available index fund in 1976. An index fund – or passive fund – merely aims to track the value of an underlying index (in this case, the US S&P 500).

“Active” funds tried to beat the market, but charged handsomely for their efforts, regardless of whether successful or not. A “passive” index fund would not promise anything more than the return on the market – but the costs would be kept very low.

Given that active funds fail to beat the market more often than not, Bogle’s creation took off (although it was ridiculed at the time). As a result, by saving ordinary investors fortunes in fees, Bogle – says Buffett – has put “tens and tens and tens of billions into their pockets, and those numbers are going to be hundreds and hundreds of billions over time.”

Pretty good work. And it’s absolutely true. Passive investing – using cheap tracker funds to get access to a market rather than paying a fund manager a big chunk of your returns to fiddle with the index weightings – is a brilliant idea, and it’s something that all investors should do in the absence of their own high-conviction ideas.

Don’t be tempted by these highly-leveraged ETFs

However, as with all good things, people do tend to find a way to mess them up. And it’s the same with passive investments.

There’s one form of passive investing that Bogle himself has never been particularly keen on. That’s the exchange-traded fund (ETF).

ETFs are index funds that are listed on the stockmarket. So you can buy and sell any time you want. You can do pretty much the same for an index fund, of course – there’s nothing holding you to it. But you don’t have the same minute-to-minute liquidity that an ETF offers.

Now, I have to say upfront that I like ETFs. They are just another form of financial technology – another tool in the box. Like any financial tool, they can be used for sensible purposes that are likely to build wealth, or they can be used for rather less sensible purposes that are likely to result in wealth destruction.

But Bogle’s goal in creating the index fund was to create a way for “buy and hold” investors to do just that – buy and hold, and not have to worry about paying big fees to outperform the market, when simply sitting tight would deliver all the returns they needed.

You see, any investor with any experience knows that you are often your own worst enemy. You think investing is easy or that you’re smarter than the average investor, so you decide that – contrary to all evidence – you’re the one who can time the market.

Plenty of data shows that this is exactly what happens. Individual investors manage to shoot themselves in the foot all the time. They chase hot funds and sell unloved ones, buying high and selling low with unerring accuracy.

Bogle feared that ETFs, despite being called “passive” investments, would encourage hyperactivity. They are just too easy to trade. And it seems he was right.

On his blog, A Wealth of Common Sense, Ben Carlson has some interesting Morningstar data on ETFs. The biggest ETF in the world – the SPDR S&P 500 ETF – tracks the S&P 500, just like Bogle’s original passive fund.

What do you think the average holding period is on this ETF? Quick – take a guess. You done?

OK, it’s 15.4 days. Not exactly buy and hold forever, is it?

And that’s the least of it. Plenty of ETFs encourage minute-by-minute trading. The US regulator has just approved a quadruple-leveraged ETF. This delivers four times the daily return on the underlying index (in other words, if it goes up by 1%, you make 4% – and of course, if it goes down by 1%, you lose 4%).

These ETFs are specifically designed to be traded on an intraday basis – if you hold them for more than a day, they rapidly stop tracking the index.

Again, the point is not that there’s anything wrong with ETFs. They’re great – they’ve opened up access to all sorts of markets you and I would have struggled to invest in previously. But that can be a problem too – it’s all too easy for all of those shiny new wrappers in the sweetie shop to distract you from the main goal.

Don’t let them. If you want to speculate, keep a pot of “play” money to back your hunches and experiment with fun new things.

For your retirement pot, you should work out your asset allocation on a piece of paper. Keep yourself away from the temptations of the computer or tablet screen.

Then decide on how you’re going to put this asset allocation into action (using ETFs, or investment trusts, or tracker funds), and only then should you go anywhere near your computer and actually execute that plan.

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