7  Passive Management

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7.1 Expense ratio

📖 The expense ratio is a fee charged by the fund to cover management and operating costs.

7.1.1 Low expense ratios are always better.

• Belief:
  • Lower expense ratios generally lead to higher returns for investors.
• Rationale:
  • Expense ratios are paid out of fund assets, so lower expense ratios mean that more of the fund’s money is invested in the market and working for investors.
• Prominent Proponents:
  • Warren Buffett, Jack Bogle
• Counterpoint:
  • There are some cases where higher expense ratios may be justified, such as for funds that provide active management or specialized investment strategies.

7.1.2 Expense ratios are not as important as other factors.

• Belief:
  • Factors such as asset allocation and investment strategy have a greater impact on investment returns than expense ratios.
• Rationale:
  • Expense ratios are a relatively small part of the overall cost of investing, and there are many other factors that can affect investment returns more significantly.
• Prominent Proponents:
  • John Bogle, Burton Malkiel
• Counterpoint:
  • While expense ratios may not be the most important factor, they can still have a significant impact on investment returns over time.

7.1.3 Expense ratios are a necessary evil.

• Belief:
  • Expense ratios are a necessary cost of investing in mutual funds.
• Rationale:
  • Mutual funds need to pay for management, marketing, and other expenses, and these costs are passed on to investors through expense ratios.
• Prominent Proponents:
  • None
• Counterpoint:
  • While expense ratios are a necessary cost, investors should still be aware of them and compare them when choosing mutual funds.

7.2 Tracking error

📖 Tracking error is a measure of how closely a fund’s performance tracks the performance of its benchmark index.

7.2.1 Tracking error is a key metric for evaluating the performance of a passive fund.

• Belief:
  • A lower tracking error indicates that the fund is closely following its benchmark index, while a higher tracking error indicates that the fund is deviating from its benchmark.
• Rationale:
  • Tracking error is important because it can help investors to assess the risk and return characteristics of a passive fund.
• Prominent Proponents:
  • Morningstar, Lipper
• Counterpoint:
  • Some investors may argue that tracking error is not a perfect measure of a fund’s performance.

7.2.2 Tracking error can be caused by a variety of factors.

• Belief:
  • These factors include the fund’s investment strategy, the composition of the fund’s portfolio, and the performance of the fund’s benchmark index.
• Rationale:
  • It is important for investors to understand the factors that can affect tracking error when evaluating the performance of a passive fund.
• Prominent Proponents:
  • MSCI, FTSE Russell
• Counterpoint:
  • Some investors may argue that tracking error is not always a negative thing.

7.2.3 Investors should consider tracking error when selecting a passive fund.

• Belief:
  • Investors should choose a fund with a tracking error that is consistent with their risk and return objectives.
• Rationale:
  • Investors who are seeking a low-risk investment may wish to choose a fund with a low tracking error, while investors who are seeking a higher-risk investment may be more willing to accept a higher tracking error.
• Prominent Proponents:
  • Vanguard, BlackRock
• Counterpoint:
  • Some investors may argue that tracking error is not the only factor that investors should consider when selecting a passive fund.

7.3 Tax efficiency

📖 Tax efficiency refers to the extent to which a fund’s distributions are taxed favorably.

7.3.1 Tax efficiency is an important consideration for investors.

• Belief:
  • Tax-efficient funds can help investors save money on taxes, which can lead to higher returns over time.
• Rationale:
  • Taxes can eat into investment returns, so it is important to choose funds that are tax-efficient.
• Prominent Proponents:
  • John Bogle, founder of Vanguard, is a proponent of tax-efficient investing.
• Counterpoint:
  • Some investors argue that tax efficiency is not as important as other factors, such as investment performance.

7.3.2 Index funds are more tax-efficient than actively managed funds.

• Belief:
  • Index funds typically have lower turnover rates than actively managed funds, which means they generate less capital gains distributions.
• Rationale:
  • Capital gains distributions are taxed at a higher rate than dividends, so index funds can provide investors with a tax advantage.
• Prominent Proponents:
  • Warren Buffett, CEO of Berkshire Hathaway, is a proponent of index fund investing.
• Counterpoint:
  • Some investors argue that actively managed funds can outperform index funds over the long term, even after taxes.

7.3.3 Investors should consider their tax bracket when choosing investments.

• Belief:
  • Investors in higher tax brackets will benefit more from tax-efficient investments than investors in lower tax brackets.
• Rationale:
  • Investors in higher tax brackets will pay more taxes on capital gains and dividends, so they need to choose investments that are tax-efficient.
• Prominent Proponents:
  • The IRS provides a number of resources to help investors understand the tax implications of their investments.
• Counterpoint:
  • Investors should not let taxes be the only factor they consider when choosing investments.

7.4 Investment horizon

📖 Passive investing is generally more appropriate for long-term investors who do not need to access their money in the short term.

7.4.1 Long-term investors should consider passive management

• Belief:
  • Passive management is generally more appropriate for long-term investors who do not need to access their money in the short term.
• Rationale:
  • Passive management involves investing in a fund that tracks a market index, such as the S&P 500. This type of investing is less expensive than active management, and it can provide investors with long-term returns that are comparable to or better than actively managed funds.
• Prominent Proponents:
  • Warren Buffett, John Bogle, David Swensen
• Counterpoint:
  • Active management may be more appropriate for investors who have a short investment horizon or who have specific investment goals.

7.5 Risk tolerance

📖 Passive investing may not be suitable for investors with a high risk tolerance who are looking for more aggressive investment strategies.

7.5.1 Passive investing is generally less risky than active investing.

• Belief:
  • Passive investing involves investing in a broad market index, such as the S&P 500, and holding it for the long term. This approach is less risky than active investing, which involves trying to beat the market by buying and selling individual stocks.
• Rationale:
  • The S&P 500 has historically returned an average of 10% per year, while actively managed funds have only returned an average of 8% per year.
• Prominent Proponents:
  • Warren Buffett, John Bogle
• Counterpoint:
  • Passive investing may not be suitable for investors with a high risk tolerance who are looking for more aggressive investment strategies.

7.5.2 Investors with a high risk tolerance may be better off investing in active strategies.

• Belief:
  • Active investing involves trying to beat the market by buying and selling individual stocks. This approach is more risky than passive investing, but it can also lead to higher returns.
• Rationale:
  • Active investors have the potential to earn higher returns than passive investors, but they also have the potential to lose more money.
• Prominent Proponents:
  • Peter Lynch, Warren Buffett
• Counterpoint:
  • Active investing requires a lot of time and effort, and it is not suitable for all investors.

7.6 Market conditions

📖 Passive investing may not be the best strategy during periods of market volatility or uncertainty.

7.6.1 Opinion 1

• Belief:
  • Passive investing may lead to underperformance during volatile market conditions.
• Rationale:
  • Passive investing involves tracking a market index and holding all its constituent stocks. When markets experience heightened volatility, these indices may experience significant fluctuations in their value, leading to losses for investors.
• Prominent Proponents:
  • Financial experts, economists
• Counterpoint:
  • Passive investing can still provide long-term returns and diversification benefits, even during market volatility.

7.6.2 Opinion 2

• Belief:
  • Active management may outperform passive investing during market uncertainty.
• Rationale:
  • Active managers have the flexibility to adjust their portfolio based on market conditions. They can increase exposure to less risky assets or sectors during periods of uncertainty, potentially mitigating losses.
• Prominent Proponents:
  • Investment managers, financial advisors
• Counterpoint:
  • Actively managed funds often carry higher fees and may not consistently outperform passive investments over the long term.

7.6.3 Opinion 3

• Belief:
  • A combination of passive and active investing can provide a balanced approach.
• Rationale:
  • Diversifying investments between passive and active strategies can help reduce overall risk and potentially enhance returns. Passive investments can provide stability and diversification, while active investments can add flexibility and the potential for higher returns.
• Prominent Proponents:
  • Investment advisors, financial planners
• Counterpoint:
  • Managing a combination of passive and active investments can be more complex and may require higher investment fees.