Skip to main content

Longboard

Insights: The True Cost of Passive Index Funds
Share:

The True Cost of Passive Index Funds

Can investors truly buy and hold?

Vanguard’s Jack Bogle changed the investment landscape by pioneering a suite of inexpensive mutual funds that strictly tracked their representative index. He argued that investors are better off simply owning everything rather than trying to pick winning and losing stocks each year. By simply buying the representative index and holding it in the portfolio, Bogle reasoned the investor would realize positive returns over the long-term.

Odds don’t favor picking winners

Longboard is inclined to agree with Mr. Bogle. Our research has found that 3 out of every 5 stocks underperforms the index and 1 in 5 stocks go to zero. Said another way: the odds are stacked against those trying to actively pick winning stocks with any consistency.

The ‘hold’ part of ‘buy and hold’ is the hard part. Investors are humans and humans can get emotional and make bad decisions when they do. Headline grabbing stories will only exacerbate this emotional process and make investors even more tempted to act against their own best interest. This up and down ride is less ‘buy and hold’ and more like ‘buy and hold on.’

Volatile days create opportunities to change

The table below reflects the underlying index tracked by the most popular exchange traded funds (by assets under management). We measured the worst drawdown, the volatility, and the number of times an index lost -3% in a single day to get a sense of how exposed investors are to volatile days, going back to January 1994.

-3% days are important because these are the days that tempt investors to sell. String enough of these days together and investors can start to lose confidence.

Source: Bloomberg

Daily returns, as of 12/31/1993 unless otherwise noted

As you can see, each market offers investors plenty of opportunities to deviate from the ‘buy and hold’ discipline.

Visualizing drawdowns

-3% days can be dangerous in the short term. For most investors, the most dangerous time is during a prolonged drawdown. As a reminder, a drawdown is when an investment is no longer at its peak value.

Drawdowns are important for two reasons. First, drawdowns are mathematically disadvantageous because the investment has to make up lost ground before it can resume compounding. If you lose -50%, you need to make 100% to get back to even.

Secondly, and more importantly, major drawdowns (over 15%) rarely happen overnight. Instead, the stock market will steadily grind down as your gains turn into losses. It can be excruciating to live through and is one of the most painful parts of investing. Throughout this stressful period, investors will be tempted to sell out to stop the pain.

The products that seek to track these indexes are helpful for diversifying returns, however, investors should be aware they lack any explicit protection from drawdowns. Part of being a disciplined, long-term investor means choosing a portfolio with the smallest emotional cost, not necessarily the cheapest headline price.

If you found yourself selling your ‘passive’ investments at any time over the last 20+ years – whether in the midst of a drawdown or not – consider an investment strategy that employs active risk management to control this exposure and lower the emotional cost of being a long-term investor.

Scroll down to see the drawdowns for the S&P 500, Russell 3000, MSCI EAFE, FTSE Emerging Market, and MSCI REIT Indexes.


[1] Assumes $1,000 invested on 12/31/1993

[2] Daily returns as of 6/17/2005

Disclosures

Longboard Asset Management, LP (LAM) is registered as an investment advisor with the Securities and Exchange Commission (SEC) and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission, nor does it indicate that the advisor has attained a particular level of skill or ability. LAM is also registered with the National Futures Association.

This website is limited to the dissemination of general information pertaining to its advisory services, together with access to additional investment-related information, publications and links. The information on this site does not involve the rendering of personalized investment advice. You should consult a professional advisor before using any of the information, pursuing any of the investment ideas or implementing any of the strategies presented. We believe the information we present is factual and up-to-date, but we do not guarantee its accuracy and you should not should not regard it as a complete and exhaustive analysis of the subjects we discuss. Our opinions reflect our judgment as of the date of publication and are subject to change.

Prospective clients can view the firm’s Form ADV and Part 2A Disclosure Brochure as filed with the SEC at http://www.adviserinfo.sec.gov/IAPD/Content/IapdMain/iapd_SiteMap.aspx or contact us for a copy.

The content of this website is provided for informational purposes only, and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation. Longboard Asset Management, LP does not provide legal, tax, accounting, actuarial or pension consulting advice or services.

Images and photographs are included for the sole purpose of visually enhancing the site. None of them are photographs of current or former clients. They should not be construed as an endorsement or testimonial from any of the persons in the photographs.

Please see our online privacy policy.

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THERE IS NO GUARANTEE THAT ANY INVESTMENT WILL ACHIEVE ITS GOALS AND GENERATE PROFITS OR AVOID LOSSES.

Definitions

Alternative investments: strategies that produce returns by taking risk other than equity and bond risk.

Bond: A debt security that shows ownership in a corporation or represents a claim in the corporation assets and earnings.

Correlation: a statistical measure of how two securities move in relation to each other.

Long: Buying an asset such as a stock, commodity or currency, with the expectation that the asset will rise in value.

Short: Buying an asset such as a stock, commodity or currency, with the expectation that the asset will decrease in value.

Stock: A security that shows ownership in a corporation or represents a claim in the corporation assets and earnings.

True diversifiers: investment strategies that have historically provided investors with at least 70% of the return of the traditional 60/40 stocks and bonds portfolios while having less than .30 bear correlation to traditional 60/40 stocks and bonds portfolios.