Monday, 7 March 2011

Book Review: The Power of Passive Investing by Richard Ferri

If ever there was any question or hope that a person could succeed in beating market returns (or their fund equivalent, market-cap weighted low-fee index funds) through investing in actively managed mutual funds, this book utterly destroys the notion. In The Power of Passive Investing author Richard Ferri presents piles of research results that slice and dice the data backwards and forwards, inside and out, upside and down. Whether it is high- or low-fee funds, past-winners, before- or after-tax, bond or equity funds, foreign or domestic investments, large funds or small, portfolios of funds, manager qualifications, Morningstar ratings, risk-adjustment that is used to select a mutual fund, none of it works better than cap-weighted index funds.

Worse, Ferri gives us the disquieting evidence that individual mutual fund investors get significantly poorer returns than even the average under-performing mutual fund because of bad trade timing.

It is thus difficult to dispute the practicality of his advice that individuals should buy passive index funds and focus their efforts instead on an asset allocation, matched with long term goals and personal circumstances (emotional strength aka risk aversion, age, wealth, job, health etc), that should change infrequently - only when the goals and circumstances do.

Ferri says it is not just individual investors who will be better off following that strategy. He makes an argument that charities, personal trusts, pension funds (especially small ones) and financial advisors should do the same to best carry out their responsibilities.

The referencing, presentation, writing style, grammar, diction and organization of the book is thankfully up to snuff (much better than another of his books that I reviewed).

That's the good stuff. Here is what I didn't like.

1) The big one:
Dismissal of active management and fundamental indexing - Showing that actively-managed mutual funds are, on average, losers, does not mean that active management, the seeking of "alpha", cannot ever work. Ferri indirectly and inadvertently (I think) recognizes such when he quotes (p.149) famed Yale University endowment manager David Swensen: "Low cost passive strategies suit the overwhelming number of individual and institutional investors without the time, resources, and ability to make high quality active management decisions". Or, on page 112, "Most of the great managers aren't for hire by the general public. The truly talented managers like to fly under the radar ... ". Or, again, on page 128 where he discusses where the dumb-money investors' money goes: "Much of it went to brokers, brokerage firms, and their trading desks. Another portion went to a handful of talented money managers who skillfully separate investors from their money". (my bolding)

He might admit that such managers really do exist (eg. Warren Buffett isn't just on a long lucky streak) but in effect says that we small-fry investors cannot tell them apart. Perhaps with active mutual funds that is so, but is it true with fundamental indexing, which he summarily dismisses on pages 75-76 with a stream of invective instead of looking at evidence? The historical performance evidence, along with the theoretical dissection of why fundamental indexing makes sense, presented most notably by Robert Arnott (whose book The Fundamental Index I reviewed here) deserves more attention than that from a smart guy like Ferri. The fact that some high-powered and neutral researchers like the EDHEC Risk Institute have effectively been trashing the value of market cap-weighted indexes for practical and theoretical reasons, suggests strongly that we, including Ferri, need to pay attention to this particular innovation, especially when it comes offered in reasonably low cost funds. The big question is whether the higher fees or tracking error of such funds (e.g. the US equity ETF from PowerShares PXF's 0.39% MER vs the classic S&P 500 ETF SPY's 0.0945%) offsets any alpha they might generate. That question is why I have the little practical side-by-side experiment going at the bottom of this blog (so far, fundamental is winning).

2) Minor annoyances:
  • the mysterious 1:2 winner to loser ratio - all through the dismemberment of mutual fund performance, Ferri keeps emphasizing that the ratio of winners to losing funds in various studies settles around 1:2 (except even more mysteriously, that the bond fund ratio is even worse at 1:4), but he never explains why. There must be a Dan Brown novel in this!
  • the big-5 lifetime financial liabilities in chapter 10 misses health costs - especially in the USA, and less so in Canada, health care costs, most likely in retirement, need to be a prime financial factor to be dealt with somehow
  • the suggestion that it is too difficult to implement passive investing on one's own (page 191 chapter summary) - "The mechanics for prudent asset allocation and investment selection are more involved than how they are presented in this book. More reading is required to a portfolio is much easier said than done. Do-it-yourself investors often do not complete the process or maintain it well." Ok, here goes: US investor - 50% VTI (or PXF), 50% AGG; Canadian investor - 50% XIC (or CRQ), 50% XBB. Rebalance annually, or never, if you are really lazy. Add money by topping up the one below 50%. Withdraw money by selling off the one over 50%. Is that simple enough? It's only a good enough, not nearly optimal solution, but it should be possible for anyone to follow.
In short, this is a very good book with one significant flaw that is more of a missed opportunity than a damaging omission, as individual investors would not go wrong following the author's advice.

My rating: 4 out of 5 stars.

Disclosure: Thanks to the author's firm Portfolio Solutions for providing a free review copy.


Canadian Couch Potato said...

Nice review, DIY. I recently interviewed Ferri and asked him about fundamental indexing. He explained that he has no issues with the methodology. His concern is the way these funds are marketed as something new and original.

In fact, many people believe that fundamental indexing is just a twist on value investing, the difference being that it weights securities by four factors rather than simply by price-to-book.

There are are several indexes that tap the value premium in different ways. Each one will have its day in the sun and its day in the doghouse. But overall, I think most indexing advocates (including Ferri) would agree that if costs and tracking error are kept low, fundamental indexing is a perfectly good strategy.

CanadianInvestor said...

Hi Potato, it's interesting to read about Ferri's interview and his being open to fundamental indexing, though it doesn't come across like that in the book.

My first reaction a few years ago was also that fundamental weighting is nothing more than a value tilt. But that changed when I read more, especially the book. Decomposing the fundamental portfolio using the traditional factor analysis shows some excess return from a value tilt and some from small tilt but the fundamental portfolio still does better - there's something else.

To me, given the theory-defying practical adjustments of the sort-of cap-weight grandaddy index the S&P 500 (arbitrary selection of constituents by a committee, float adjustment) and the risk-adjusted evidence of inferior cap-weight index performance (Sharpe, Sortino, Information ratios etc), the fundamental index method seems worth a serious look.

Canadian Couch Potato said...

DIY: No questions, the flaws in cap-weighted indexes are real. But total-market indexes get around many of the problems of the S&P 500 and others that involve arbitrary selections.

I agree that Arnott's book is very compelling, and I would never try to talk some out of using the RAFI strategy.

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