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The power of passive investing

 

In this second part of the series, I will be putting up a case against the active management of funds and also to structure a strategy to align our returns to the market index.

Difference between passive and active investing

Active investing is a strategy to actively buy and sell stocks within a portfolio, hoping to gain an abnormal return out of it as compared to the index. This takes the form of Unit Trusts, whether it’s in the form of holding an account with Fundsupermart or buying the product through a financial institution. Passive investing is a strategy to buy and hold stocks within a portfolio. This is closely associated with ‘buying the index’ where an index in Singapore context consists of 30 companies weighted by their market value.

Case

My case is that passive investing will outshine active investing in the long run. Investors are better off investing passively, to go with the market instead of trying to beat them. To go with the market means to obtain returns similar to market returns. For example, if Straits Times Index (STI) returns 6% per annum, the investor will have done a great job if he/she is able to earn that 6% as well. Now, some of you may ponder, “why obtain something that is a given? We must aim for more”

The reason why active investing will never outshine passive investing lies in the fees! The fact that the fees are recurring means that it will create a dent in your wealth over a long period of time. Let me substantiate.

Two friends decided to invest the same amount of $20,000. One bought a stock index, the other a unit trust from Fundsupermart. Prospectuses are available Vietnam Stock ETF (page 108) and LionGlobal Vietnam SGD . I am showing the impact of the recurring fees.

LIONGLOBAL VIETNAM SGD DBXT Vietnam 10US$ (HD9)  Net difference
Initial Amount Invested

$20,000

$20,000

Annual Expense Ratio

1.80%

0.85%

Net Return assuming 8% return from the Vietnam Stock Index

6.20%

7.15%

Wealth after 30 years

S$121,553

S$158,780

S$37,227

Wealth after 50 years

S$404,814

S$631,886

S$227,072

Wealth after 60 years

S$738,756

S$1,260,551

S$521,795

The results are staggering. Half a million over a 60 year period?! On a sidenote, there’s a piece in the Sunday Times questioning about whether CPF is enough to cover retirement. Half a million surely helps in my case! Over the life of 60 years, the difference in the fees of 0.95% compounded has a huge impact on the wealth between the two friends. 1.8% in fees may seem very little in absolute terms but in actual fact, it is a costly mistake leading to wealth degradation.

Evidently, academics have also proved that active management of funds underperform index funds. Burton. G Malkiel of Princeton did a research on returns and market efficiency. Read Here. (You don’t have to read the research paper, just scroll down to page 5 – 7 to have a look at the comparison between the returns.)

Another point I want to bring out is timeframe. In my introductory statement, I stated that “passive investing will outshine active investing in the long run.’ The key is long run. This means that actively managed funds can earn a higher return in the short-run but the thing is how do you know which fund will outperform the index? There are thousands of funds to choose from. Choosing funds with the highest return in the past will not help! Forecasting future returns using past data is statistically wrong. This is backed up by academic research as well. Take a read Here. In addition, to invest is to take a long-term approach towards it and if that’s the case, shouldn’t we have a forward-looking view instead of picking the short-term winners? (That is if you managed to pick one.)

Portfolio

Knowing that unit trusts will most probably never beat passively managed funds, what can we do? We can structure a portfolio of index funds and bond funds and to rebalance them once in 6 months or annually. For example, my asset allocation is in terms of 20% bonds and 80% stocks. Initial investible amount is $50,000. The value of bonds will be $10,000 and the value of stocks will be $40,000.

Let’s say, 6 months down the road, the value of stocks increased to $55,000 and the value of bonds decreased a little to $9000. I will have to rebalance my allocation back to my target allocation of 20% bonds and 80% stocks. Total value now is $64,000. I will have to sell $3,800 (55000 – [64000*0.8]) worth of index funds and buy $3,800 ([64000*0.2] – 9000) worth of bond funds. The idea is to buy low and sell high. Sell the stock value at a higher price and buy the bond fund at a low price. Doing this consistently will ensure that you take advantage of selling high and buying low. Why? As a long-term investor, we want something that is very cheap now because we still have a long way to go in terms of lifespan. Something that is cheap now has a higher capacity for it to go higher. I am giving credits to Andrew Hallam, the author of “Millionaire Teacher”. It is a fantastic read and it opens up my knowledge to index investing.

On a personal recommendation, have a sum of money invested passively and with the leftovers, one can do the actively buying or selling or shares for short-term gains if he/she in interested in trading/investing. To conclude, knowing what you buy is important and knowing what you have to pay is even more important. Be satisfied with market return and let the power of compounding do its job. Yay..

 

 

Royalty-free photo from Getty Images. Used with appreciation.

 


 
 

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