Crucial Retirement Investment Strategy: Misunderstood by Nearly Everyone
Passive is powerful, but what’s it mean to you?
A survey of nearly 6,000 households asked, in multiple choice format, the definition of “passive investing.” More than half chose “didn’t know.” Another 29% incorrectly chose “buying and holding without being influenced by short term market fluctuations.”
Only one in five retirement savers, in the quiz by Hearts & Wallets, correctly identified passive investing as “investing in an index, often weighted to market capitalization.”
A wrong answer on this one has big financial repercussions. People who didn’t know the definition of passive investing were less likely to be tucking away money in an individual retirement account. And those who were investing tended to hold a lot more cash than stocks — a great way to lose ground to inflation.
Understanding passive investing and making it the centerpiece of your strategy can add tens of thousands of dollars to your retirement pot. Good news: It’s not hard to grasp, and it’s easy to implement.
When you hear “passive” think “index.”
When you’re investing for retirement, chances are you own mutual funds. Workplace retirement plans, such as 401(k)s, offer a lineup of mutual funds, or their close cousin, a collective investment trust. Mutual funds are also a popular choice for individual retirement accounts (IRAs) you own directly through a brokerage account.
Each mutual fund you own typically owns dozens, if not thousands, of individual stocks and bonds. That makes mutual funds a super easy way to own a diversified portfolio.
Every mutual fund uses one of two strategies. A passive/index fund opts to track the holdings in a given index. For instance, the S&P 500 is the most popular U.S. stock index. An S&P 500 stock index fund will own the 500 stocks in that index. Period. No investment pro is sticking their neck out and deciding to own more of one stock and less of another. That’s where the “passive” comes from: Index investing is set it and forget it.
The other way a mutual fund can operate is to give the reins to an investment pro, who decides what stocks or bonds to own. When a human being is making investing decisions, this is referred to as “active” investing. Unlike passive investing that resolutely tracks a market index, active investing relies on the decisions of money managers.
Passive is more profitable.
“Active” funds don’t, on average, produce better returns than an index fund with a similar investment objective. According to Morningstar Direct, which publishes a definitive “Active v. Passive” report, no matter the time period, index funds (and exchange-traded funds, or ETFs) tend to do better. For the 10 years through June 2020, just one in four active funds had a return that was better than similar index funds and ETFs. (Morningstar compares funds with similar investment objectives. For instance, active core bond funds are compared to core bond index funds.)
The indexing edge is even more pronounced for funds that focus on big U.S. companies that are the heart of the S&P 500 index. For the past 10 years, less than 10% of actively managed funds that focus on those big stocks outperformed index funds with the same focus. Over 20 years, less than 15% of active managers did better.
Managers aren’t dolts, but they are more expensive.
The main reason actively managed funds tend to underperform is because you pay more to invest in that fund. The different fee structure for active and index funds can add up to tens of thousands of dollars by the time you retire.
Mutual funds charge an annual fee, called the expense ratio. The thing is, you never see “expense ratio” as a line item deduction/cost in your fund statement. Instead it is just skimmed off the fund’s performance before reporting your return to you. Out of sight can mean out of mind, but it is so important to focus on low-cost funds or ETFs.
According to Morningstar, the average actively managed fund charged an annual expense ratio of 0.66% in 2019. The average index fund charged 0.13%. That average gap of more than half a percentage point a year is effectively a hurdle active management has to scale just to keep up. Most can’t do that consistently.
And for the record, a half a percentage point is not peanuts when it comes to building retirement security.
Let’s say you start at age 30 investing $500 a month and the gross (before fee) annualized return of both an active fund and an index fund is 7%. By age 70 if you invested in an index fund or ETF charging an 0.13% expense ratio — reducing your net return to an annualized 6.87% — you will have more than $1.26 million.
If you invested in an active fund with an 0.66% expense ratio, your account will have grown to nearly $1.1 million. That’s an extra $160,000 come retirement just because you focused on being a passive investor, who used low-cost index funds.