Just 30 kilometres outside of Philadelphia, Pennsylvania sits the sleepy town of Malvern. Population 3,419. The town was best known as the site of the obscure battle of Paoli in the American Revolutionary War where British regulars surprised American militia in a night attack. The town is now known for something else. It is the headquarters of Vanguard which manages just under 12.5 trillion AUD in assets. That is a hard number to wrap one’s head around. But it is more than 5 times Australia’s GDP. Vanguard could buy every publicly traded company in Australia – 7.8 times.

For years there has been a debate between active and passive management. It may be too early for either side to declare victory, but the momentum is certainly with passive. While Vanguard didn’t start passive investing they championed it relentlessly under their founder John Bogle. More than anyone else it is Vanguard that is responsible for popularising the approach with investors.

Yet the real lessons from Bogle are being ignored. The irony of the debate is that investor behaviour may be so poor that neither active or passive investing work for the majority of investors.

What is wrong with active management?

Active management has been much derided. High fees, frequent turnover and poor tax outcomes are just some of the criticisms that have been levelled against active management. It also doesn’t help that active managers have consistently underperformed the index. The latest Morningstar Active / Passive Barometer report showed that only one out of four active funds outperformed the index over a ten-year period through December of 2022.

When passive investing came onto the scene active managers were complacent. As the industry continued to grow the active fund managers kept the cost savings achieved through scale. Savings were not passed on through fee reductions. As competition from passive funds increased fees finally started to come down. In the US active fund fees have dropped 40% since 1994. This is investor friendly but still trails the 60% decline in passive fees. At the end of 2022 the average active fund charged a fee of .59% while the average passive fee stood at .12%.

Active management fees will always be higher than passive fees. The people managing the money need to get paid. And they get paid a lot. A higher fee does not mean that active management isn’t the best choice for investors. It all comes down to the manager making good decisions.

The issue is that there is little evidence that the average active manager is making a good decision. Most portfolios managers can’t help but churn their portfolio. In press interviews and marketing material we hear a lot about long-term investing. And there is a reason that such an emphasis is put on long-term investing. It works. According to the Institute of Business & Finance the average turnover rate of equity funds is between 90 and 100%. That means that at the start of the year 90% to 100% of the positions in an equity fund are new by the end of the year.

Professional investors know better. They know that frequent trading is correlated with lower returns. They know that frequent trading generates capital gains and increases transaction costs. While they may not show up in the performance figures of a fund it makes the after-tax outcomes much worse for the end investor. The reason that fund managers continue to do something they know is wrong is because most professional investors are faced with a conflict between what is good for their careers and what is good for investors.

There is supposed to be alignment between professional managers and end investors. Compensation is aligned to performance which in theory means that strong performance will benefit both the manager and the end investor.

The problem is that the risk for a manager is asymmetric. Strong performance over the long-term is generally aligned to higher compensation for a manager. But weak short-term performance can lead to investor outflows and might put the manager out of work. And even a poorly paid portfolio manager is well paid. Not a job anyone wants to lose.

We can criticise professional fund managers for their short holding periods. Yet we need to acknowledge that their need to keep up with the index over the short-term is based on our impatience. Individual investors chase performance. A study by Barber and Odeon at the University of California found that over half of managed fund purchases by US investors were in funds that ranked in the top quintile of returns.

And there is reason to believe that investors change funds with increasing frequency. The average investor holds a share for 5.5 months according to Reuters. And this wasn’t always the case. In the 1950s the average holding period was 8.8 years. There is no reason to believe this reduction in holdings periods doesn’t apply to funds and ETFs.

Does passive investing work any better?

Go back and read the way John Bogle describes passive investing. The idea is relatively straightforward. Pick your asset allocation. Gain exposure to each asset class using a broad-based index and don’t sell. Trust that over the long-term low fees and better tax outcomes will make a difference. And remain cynical that any investor can consistently pick the best performing shares. As Bogle summarised the approach, “Don’t look for the needle in the haystack. Just buy the haystack.”

What I described above is a passive strategy. Nobody is picking individual investments that go into a fund or ETF and the end investor is not picking what product to buy and sell or when to buy and sell those products.

This is a compelling strategy that has attracted legions of investors to the passive camp. The problem is that there is a difference between passive investing and using passive investment products to actively invest. Buying and selling different passive investments is not passive investing. Stretching the boundaries of what is considered passive to narrower and narrower indexes that promise exposure to a compelling theme is not passive investing. Investing in products that follow an index with high turnover through constant rebalancing is not passive investing.

John Bogle famously criticised ETFs. He knew the danger of poor investor behaviour and was worried that the biggest selling point for an ETF – the fact that they are easy to trade – would lead to more trading. He was right. A study conducted by UTS explored whether individual investors benefit from the use of ETFs. The study found that portfolio performance when investors used ETFs was lower than when they didn’t.

It wasn’t a small loss. The study found that ETF portfolios underperformed non-ETF portfolios by 2.3% a year. The loss is the result of buying ETFs at the wrong time rather than choosing the wrong ETFs. A critical finding in the study was that ETF portfolios did actually outperform if the investor bought the investment and held it for the long-term. My colleague Shani explored this issue further. Is there an inherent problem with ETFs? Of course not. The problem is us.

What is the lesson for investors?

There is a difference between investments and investing. An investment is something you buy and sell. Investing is a process. The success of any process comes down to a few common traits. Patience, resilience, and consistency lead the list. Investing is no different.

The inconvenient truth about investing is that our own behaviour is having a negative impact on the approach taken by professional investors and is hurting our own returns. And nobody seems ready to admit it. Many investors have created a narrative that flies in the face of reality. Fund managers tell anyone who will listen that they are long-term investors. Yet many of them churn their portfolios.

Active fund and ETF investors tell themselves that they are letting professionals manage their money because they think it is too hard to pick individual shares. Yet they constantly switch which professionals are managing their money based on short-term performance.

Passive fund and ETF investors are holier than thou. They quote John Bogle ad nauseum. Yet they switch passive investments constantly based on their perception of what will do well given short-term market conditions. They buy high and sell low. They decide anything tracking an index is passive. Even if that index has 10 shares that are selected fortnightly using a Ouija board.

I think both active investing and passive investing can work. But I don’t think that active investment works in the way that it is practiced by many managers. And I don’t think passive investing works in the way most end investors practice it.

My point is simple. In investing we have met the enemy…and he is us. Changing your behaviour is hard. It means ignoring articulate people making compelling cases for and against investments. It requires immunity to highly paid and skilled marketers. It means dulling your emotions as your portfolio climbs and falls.

One of my favourite things about investing is that it is all about me. It is me against the world. Maybe the playing field isn’t level and professionals have more time and resources than I do. Maybe they know more than I do. They are likely far smarter than I am. But I have control over my outcomes. And a lot of it comes down to the basics. Having a goal. Coming up with a long-term strategy. And resisting the temptation to constantly chase returns.