Listen to this post
Back in 2008, Warren Buffett made a very bold bet against hedge funds.
With their high management and performance fees, hedge funds are actively managed by professional investors. Buffett believed that the average person was better off investing in an index fund and taking advantage of the longer-term benefits of “passive” investing.
The famed value investor and CEO of Berkshire Hathaway bet $1 million against a hedge fund manager named Ted Seides, head of Protégé Partners LLC. The bet: that the S&P 500 would have a better 10-year performance than the hedge fund’s returns.
In 2017, Seides conceded defeat. In a Bloomberg opinion piece, he wrote: “[F]or all intents and purposes, the bet is over. I lost.”
The bet was important because it publicized the two fundamental investment philosophies of the world today: passive and active investing.
I’ll break down the pros and cons of a passive long-term approach today.
Defining Active Versus Passive
Active investment strategies are exactly as they sound. Money managers or retail investors actively buy and sell stocks based on the expected performance of a stock.
You’ve probably heard of Bill Ackman, the founder of Pershing Square Capital Management. Ackman buys large amounts of a company stock, aims for a specific target performance, and tries to beat a benchmark, typically the S&P 500’s performance.
Passive investing, however, is measured by those benchmarks. For example, investors can purchase index funds or exchange-traded funds (ETFs) that replicate the performance of an index like the S&P 500.
The SPDR S&P 500 ETF (SPY) tracks overall performance of the entire index of the 500 largest publicly traded companies in the United States. Rather than hand-picking stocks or bonds for the fund, a fund manager would — in this case — buy all of the assets that the index tracks.
The Pros of Passive Investing
Anyone who invests passively in an index fund or ETF should be buying and holding for the long term. Effectively, the goal is to maximize the return from the performance of the entire stock market.
The stock market has a historical bias to the upside, so investing in an index fund offers this benefit. While there may be short-term downturns, one can look at the performance of the S&P 500 over the last decade and see that patience pays off.
Other primary benefits of passive investment include the low costs associated with index funds and the diversification benefits. The broad allocation of stocks in an index fund or index-tracking ETF enables you to benefit from the absolute performance of that index.
And I must highlight that passive investments can produce better after-tax results. With an active strategy, investors might be compelled to buy and sell within a 12-month horizon.
The U.S. tax code requires that investors pay any capital gains generated within 12 months as ordinary income. However, any investment held longer than 12 months that is sold will operate on long-term capital gains taxes, which can be significantly lower than taxes for ordinary income levels.
The Cons of Passive Investing
The cons of passive investing might not impact the morale of a long-term investor, but they are worth noting.
First, you’re not going to beat the market as a passive investor, because you’re effectively buying the total performance of the market itself. In fact, after fees, you’ll trail the benchmark by a small amount.
Second, passive investing is, well, passive. It might be a little boring on the surface. So, if you’re a person who likes to trade stocks and conduct deep research, you’re not going to get the same action.
Next, you’re not going to be able to react to any significant downturn in the market right away. Your money is tied directly to the whims of the broader market and the macroeconomic events that might cause a sell-off.
However, there are various strategies that you can employ in order to reduce broader risk and potentially maximize your returns.
Even if you are investing for the long term, you need to treat the S&P 500 or other index like any other stock. Therefore the same rules apply around trailing stops, momentum, and risk management.
With TradeSmith Finance, investors will know the exact moment when an index fund like the SPY has stopped out. By following these rules, you’ll also know when momentum has returned to the market and it’s time to reenter. Following such rules enables you to potentially buy back in at a lower price and potentially earn far greater returns over the longer term.
Tomorrow, we’ll talk about a few other passive investments out there that allow you to take advantage of long-term trends. I’m especially excited about a few alternative energy commodities that can maximize returns on a few breakout trends in the coming decade.