Active vs. Passive with Rick Ferri – Part 1

RICK FERRI INVESTING APPROACHThis week, Devin welcomes Rick Ferri to the show to talk about active versus passive investing.

But before the interview gets started, John and Devin have an entertaining conversation about the recently released 2019 Social Security and Medicare adjusted numbers, including:

  • the increase in Social Security benefits
  • increased Medicare premiums
  • adjusted Social Security earnings limit
  • higher limit on how much money you will pay Social Security benefits
  • higher amount you need to earn a Social Security credit

And then, on to the interview with Rick Ferri.

Rick got started as a stock broker, and began tracking his client’s outcomes compared to the outcomes of the market of the whole. He began questioning whether he was doing the right thing, because his clients were rarely performing better than the market benchmarks. And even when the clients did perform better than the benchmarks, it wasn’t persistent performance. As a result, he started questioning the value of active management.

So, what’s the difference between active vs. passive investing?

Passive are the returns of a broad market index, like the US stock market. An example is the S&P 500, which is trying to emulate the returns of the market as a whole. It isn’t perfect, but it’s trying to give you the return of the market. You’re not trying to outperform the market. It’s the same with the bond market. You’re not trying to outperform the market, you’re trying to just be the market. Active management is striving to beat the market. 

Indexing is synonymous with the idea of passive investing. Indexing is very popular right now. Ten of the 11 largest mutual funds and ETFs in the world are now passive.

Let’s just dive into that for a second. No one is saying that fund managers who are trying to be active are dumb, or not skilled. There are going to be some who will outperform the market. The reason why indexing has worked in the past and will continue to work in the future is because of the difference in fees. Active investing has a lot of expenses just to break even, and then they are trying to make a profit on top of that.

There are good active managers out there, and sometimes they can outperform the market for a specific period of time. However, in the long run, it gets harder and harder to outperform the market as a whole. The longer you invest, the greater the odds of performing better in an passive index fund than in active management.

So, why do people remain invested in actively managed fund? Rick points out that it takes a decision on the part of the investor to take an interest in this and calculate how they are really doing.  You’re talking about taking the step where people are willing to sit down and analyze the returns on their portfolios, to come to the conclusion that they are fees, and to come to the conclusion that they are underperforming. A lot of people have no interest, or don’t know how, or decided that they’re just going to trust their advisor. They’re not going to take the step or they don’t know that they’re supposed to take that step because they believe their financial advisor.

For these folks, they won’t move over to the low-cost, passive side until they come to the realization that they are not keeping up with the market. Only then will they have that a-ha moment, and that’s what keeps the brokerage firms alive.

Devin points out that there are some big dollars being spent to prove that active management is more successful than passive investing. The big mutual funds have created massive amount of content about how active management is better. Devin looked at some of the arguments that the pro-active management

Point one: the active versus passive management is cyclical. Rick says that yes, it is cyclical, but the problem is that it is about 70% passive and 30% active. So then the challenge is to know which section is going to outperform next, and then you have to pick the right funds that are going to outperform, and then you have to get out of it before the active funds are going to start underperforming. During all of this, the market continues to march up, and your performance isn’t keeping up with the markets because you’re following the trend.

Come back next week and listen to the rest of the arguments that the actively managed people are bringing against the passive investing folks! It’s fascinating!

Resources mentioned in this episode:

Rick’s Books:

Serious Money
All About Index Funds
All About Asset Allocation
The Power of Passive Investing
The Bogleheads Guide to Retirement Planning

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