Does indexing work? Active Versus Passive Asset Management

Recently, I read a book by Charles D. Ellis called Figuring It Out. This book is mainly a compilation of his best essays to investors over the last 60 years. He has been around for along time in the asset management business, advising many organizations from Yale to Vanguard. In my mind, he is the asset management business equivalent of Warren Buffett. He not only is well respected, but also, he can explain the history of the business going back many decades. After all, he lived through it.

Active management is when a manager doesn’t look anything like his or her benchmark (index/market) and is trying to outperform the benchmark. Some active managers would even say they are trying to achieve a market-like or better than marketlike return with less risk. Typically, this type of management style comes with an elevated cost. Passive management is essentially the index/market.

This style of management tends to be much less expensive than active management, due to the funds weighting themselves according to whatever index they are trying to track.

mine wrote a letter regarding indexing a couple years ago, saying, “Given the flows of money into indices, and out of everything else, shares in indices have enjoyed years of rising demand, helping to raise their prices while shares not in them have been ignored or sold to fund the switch. What will happen to demand for these popular shares when indexing reaches a steady state?”

Money Matters

I believe that, like all things in life, moderation is important. I believe indexing has its place, and I’m a fan of it. There is a lot to like; however, I also like certain things you can get in active management that you can’t get in passive management.

In my opinion, there is value in deep research and fishing in parts of the pond that others may not be fishing (so long as there are fish). Customization can add immense value to certain clients, which is difficult to achieve with indexing. Is there a higher cost? Yes, but there is a lot more work that must be done.

Lee Williams

Charlie is passionate about indexing. He believes the market today is highly efficient due to the number of qualified professionals who transact in it. These people are very skilled and well educated. They have access to troves of data at the click of a mouse. Many years ago, it was easier to find inefficiencies in the market, as there were less data and fewer people educated the way they are today.

It is hard to argue with him on any of this. About a decade ago, Eugene Fama did a study of all domestic mutual funds with at least 10 years of results. He concluded that, after costs, the top 3 percent of managers produce a return that indicates they have sufficient skill to just cover their costs, which means that going forward, and despite extraordinary past returns, even the top performers are expected to be only about as good as a low-cost passive index fund. The other 97 percent can be expected to do worse.

There are many studies on indexing and the benefits of indexing. Does it work?

Yes, in my opinion it does work, but like anything, it has its shortcomings, too. It’s hard to customize a portfolio by just owning an index or multiple index funds. Tax loss harvesting becomes difficult for those in high income brackets. A famous investor friend of

Ultimately, I believe every situation is unique, and it’s hard to give blanket recommendations. Due to these reasons, I tend to skew towards a blend of active and passive management. Wealth can be created in many ways. Whether engaging in active or passive management, the key is to find something you believe in, and stick with it.

~ Lee Williams offers products and services using the following business names: Lee Williams – insurance and financial services | Ameritas Investment Company, LLC (AIC), Member FINRA/SIPC – securities and investments | The Ascent Group, LLC – investment advisory services. AIC is not affiliated with Lee Williams or The Ascent Group, LLC. Information gathered from sources believed to be reliable; however, their accuracy cannot be guaranteed. Actual prices may vary. Securities are subject to investment risk, including possible loss of principal. This material if for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. While we believe the information provided is reliable, we cannot guarantee its accuracy. Opinions expressed are subject to change without notice and are not intended as investment advice or a solicitation for the purchase or sale of any security. Please consult your financial professional before making any investment decision.