Why Passive Investing is Better Than Active

Numerous studies have shown that, over time, active investing underperforms a passive approach. There are several contributing factors, including:

So why doesn’t everyone invest passively? Taking the long-run view requires patience, and marketing is a powerful lure. Investors don’t want to match or slightly trail the returns of the market (when you factor in expenses); they want to beat the market, and that is something a passive index fund by definition cannot do. Instead, they fall for a good story: a team of smart investment professionals who have a secret strategy or the latest technology can deliver better than the market’s returns.

The reality is, there are three basic ways to make money investing in markets:

  1. Find undervalued opportunities before everyone else.
  2. Invest in the broad market over the long run, as through long-run economic gains, companies across a market deliver increasing value to their owners.
  3. Minimize costs.

Searching for undervalued assets has a strong, but illusory lure; the wealth manager just has to be smarter and faster than everyone else. The problem is that there are literally thousands of money managers, all looking for undervalued opportunities. The New York Times reported that over the six year bull market (2009 – 2015), not a single manager (out of 2,862 stock market funds) could sustain performance ranking in the top quartile of managers for all six years.

Even if a fund manager successfully tops the market for a few years, it’s very difficult to sustain that outperformance over a long period of time. Put simply: it’s extremely difficult to outsmart everyone consistently enough to beat long-run passive index performance. If it’s impossible to find a consistently excellent fund manager, why should investors pay high fees to the fund?

Index funds, on the other hand, don’t try to outsmart the market. By purchasing everything in the market index in the proportions the securities comprise the index, the fund manager aims to match the market’s performance. Some assets will increase in value, some will fall, but in sum, the index fund performance matches that of the market.

Moreover, with index funds or ETFs, investors capture value through long-run broad market gains while minimizing costs. Index funds pass on lower costs to their investors, because management costs are lower, transactions costs are less frequent, and taxes tend to be smaller.

Using an active fund manager puts higher costs on the investor: the fund manager receives a large salary, paid through the expense ratio (often 1% or more of the investor’s managed assets); fund trading costs, which may be high as the manager trades frequently in search of opportunities; and higher taxes. Even if the active manager is successful at beating the benchmark, these extra costs can often outstrip any gains for the investor.

Essentially, because they manage investor money at lower costs, index funds can increase the investor’s after-tax, net returns.
Aaron Gubin
Aaron Gubin leads research for SigFig’s Wealth Management team. He holds a Ph.D. in Finance and taught investments and portfolio management to graduate and undergraduate students before coming to SigFig. His research focuses on asset allocation, behavioral finance, and investment management.

In uncertain times, a diversified portfolio enables investors to stay the course

The last few months have been uncertain times for U.S. investors. After years of marching relentlessly higher, U.S. equity market growth has pared to a modest 3-4% since the end of 2014. In spite of the modest recent performance of US equities, many investors feel that many asset classes are “expensive.”

Investors have many questions: has the U.S. stock market peaked? When will the central bank begin to increase interest rates? What are the prospects for emerging and developed markets? We will discuss these questions, and their implications, below.

More than anything, investors are probably wondering what they should do. We strongly believe that in times like these, investors need to stay the course, with a diversified portfolio that has the risk-appropriate mix of equities and bonds. The markets could be poised for a pullback — or for several more years of growth. Adjusting a portfolio in anticipation of future market movements usually underperforms a long-term strategic allocation held through market cycles.

 

For the U.S. stock market, mixed signals

Throughout the last several quarters, signs of a sustainable, healthy U.S. economy have been mixed, leaving investors with lots of questions about the future. Unemployment is still trending down, reaching 5.4% in April. However, continued slack (excess capacity) in the labor market has left wages stagnant throughout the recovery, with few signs of future increases. Inflation remains below 2%, and company profits, which had reached all-time highs in 2013, abated slightly in 2014.

These signals have led U.S. equities in a mostly sideways trajectory for the last several months, with little clarity promised on the immediate horizon. Though U.S. stock market indices have hit all-time record highs, there aren’t major structural issues in the economy that should derail continued stock market increases.

S&P 500 CHART

(S&P 500 performance for the 12 months ending May 19, 2015.)
 

Timing uncertainty over interest rate hikes

Fixed income markets remain high as central banks around the world keep interest rates at historic lows. The Federal Reserve will eventually bump their benchmark lending rate up, pushing bond values down. However, the timing of the rate increase remains uncertain. Though Fed watchers think the central bank will nudge their benchmark rates higher as early as September, the last two quarters produced annualized GDP growth of just 1.2%. Perhaps this tentative performance may lead the Fed to postpone their rate hike.
 

Continued growth for developed markets

In contrast to the United States, developed markets have performed well over the last six months, as major central banks around the world initiated monetary easing policies and international economies emerged from recession. Debt concerns among many southern European nations (Italy, Spain, and Portugal) receded, though Greece’s fate as part of the Eurozone remains uncertain. Even with global political issues weighing on markets (e.g., Ukraine-Russia border skirmishes and Iranian nuclear negotiations), prospects for continued growth among international economies appears strong.

EFA CHART

(12-month performance chart of EFA, an index fund tracking the MSCI EAFE Index)
 

Emerging markets uncertainty

Meanwhile, emerging markets have also bounced back from weaker showing in 2014, with help from an uptick in oil prices and interest rate reductions in China. Nonetheless, future growth is uncertain as global demand for oil and emerging economy exports fluctuates.

EEM CHART
(12-month performance chart of EEM, an index fund tracking the MSCI Emerging Markets Index)
 

The importance of staying the course in a diversified portfolio

When there is uncertainty on the horizon, a balanced, well-diversified portfolio is what investors need, as it enables profit in upward markets and protection against downward movement.

It makes good investing sense to avoid tactical market timing, because adjusting a portfolio in anticipation of future market movements usually underperforms a long-term strategic allocation held through market cycles from top to bottom and back. It’s better to hold a risk-appropriate portfolio for the long run than sit on the sidelines hoping to avoid an imminent crash, while the market continues a strong run.

As always, it’s important for all investors to confirm regularly that their portfolio allocation matches their risk tolerance, enabling them to ride fluctuations that affect any specific asset class.
Aaron Gubin
Aaron Gubin leads research for SigFig’s Wealth Management team. He holds a Ph.D. in Finance and taught investments and portfolio management to graduate and undergraduate students before coming to SigFig. His research focuses on asset allocation, behavioral finance, and investment management.

Investor Tip: Selecting Which Tax Lots to Sell First Could Reduce Capital Gains

Imagine that you’ve been investing in a certain stock, mutual fund or ETF over the last 18 months, buying 10 shares of it once every three months. Now, after some ups and downs in the share price, you’d like to pare back your position. Maybe you need that cash to pay bills, put a down payment on a house or buy a boat. Or maybe you’ve just retired and are starting to plan your withdrawal strategy for living expenses.

Whatever your circumstances, one of the most important factors to consider is how the sale will affect your tax bill.

The way many brokerages deal with a sell order is known as FIFO: First In – First Out. It prioritizes selling long-term positions before short-term positions. In other words, the brokerage will first sell the shares that you bought the earliest.

However, there’s a better order that you should follow in selling your shares that can help you at tax time.

When selling shares at your broker, you can typically specify which lot to sell from (each buy creates a new tax lot).  The list below suggests the order in which you should sell lots, though you can pull from multiple lots in the same sale transaction. Remember that it is usually preferable to minimize trading (and the transactions costs that it implies) as much as possible.

1. Sell short-term losses first.

Offset any short-term capital gains (which would be taxed at your marginal rate) realized this year.

2. Sell long-term losses.

Offset any long-term capital gains you’ve realized this year.
If you have more total losses than gains, you can offset up to $3,000 of your current income.

3. Sell long-term gains (if necessary).

The tax rate on long-term gains is lower than the tax rate on short-term gains, so it makes sense to prioritize the sale of long-term gains before short-term gains.

4. Sell short-term gains (if necessary).

The tax rate on short-term capital gains is the same as your income rate, so there’s no benefit to making sales of short-term gains before liquidating other types of lots.

Though the default order at the brokers is typically FIFO, you should check and see if you can change it: a Loss Harvester option should implement this order without forcing you to pick the specific lots. (It’s worth noting that the Loss Harvester option may be default at some brokerages.)

Here’s a visual example that will hopefully clarify the strategy further. The chart below shows the price movements of a fictional stock, which you first bought on November 30, 2012, at $105.69. In the following year and a half, the stock price moved up and down, and you continued to buy, at anywhere between $129.45 on August 31, 2014 to $108.87 on November 30, 2014 (the last time you made a purchase).

Screen Shot 2015-02-11 at 10.55.54 AM

Now that you want to pare down your position, where do you start? Based on your per share lot cost basis and the stock’s current price ($109.61), you would order a sale on three of your more recent transactions first. The most recent purchase – that made on November 30, 2014, is a short-term capital gain and should be sold last, if at all.

The chart below shows you how the rest of the lots should be prioritized, if they need to be sold at the current price.

TaxTipCapGains

Note that the information presented here is meant to explain general tax-efficient strategy and does not present specific investing advice. For that, investors should confer with their tax advisor.

Aaron Gubin
Aaron Gubin leads research for SigFig’s Wealth Management team. He holds a Ph.D. in Finance and taught investments and portfolio management to graduate and undergraduate students before coming to SigFig. His research focuses on asset allocation, behavioral finance, and investment management.

How to Navigate a Market Downturn

The hardest part about being a disciplined investor is maintaining a patient, thoughtful approach in the face of market headwinds. It’s tempting to sell your portfolio and wait out the storm, at least until things seem to have settled down.

Worldwide, stocks have fallen significantly and volatility is higher. Developed equities have fallen 10% from their highs and the S&P 500 dipped 7.5% in the last month; 10-year bond yields briefly fell back under 2%. Over the last month, a 60/40 stock/bond portfolio — a common asset allocation benchmark — is off more than 4%.

Common reactions are to hit the panic button and liquidate everything and wait. When our investment decisions are made on fear, however, we’re running from the smart, calm approach that should guide our rational long-term planning. Instead, the smart, long-term approach is to stay the course.

The chart below shows the S&P 500 over the one-month period from July to August 2011. The S&P 500 fell almost 15% in the month. The market had been on a tear through mid July, up 50% from its 2009 lows.

Screen Shot 2014-10-15 at 3.51.30 PM

If you jumped out of the boat in August 2011, nervous that stocks were overvalued, you’d have missed a big chunk of a great market rally. Over the next three years, the market was up 68%.

Screen Shot 2014-10-15 at 3.52.30 PM

The research says stay the course. Don’t try to time the market. Invest, confirm your risk tolerance, harvest available tax losses.

  • Don’t try to time the market. Attempts to time the market, by jumping out at initial signs of market tops, or jumping in at signs of market bottoms, underperform a disciplined, buy and hold, stay the course approach.

    Most finance research indicates it is nearly impossible to figure out where the market is going (minutes, days, weeks, months, or years from now). It is impossible to know if the markets will move higher in the coming days or continue with volatility. (Even the so-called experts do not beat the market reliably.) Still, markets historically reward smart, disciplined risk-taking over the long-term: investors take on risk by investing in companies and are rewarded with capital gains and dividends.

  • Invest. We’re big proponents of setting up regular, recurring deposits. These serve three purposes: They build your account value, getting more of your assets to work for you. Deposits enable a simple rebalancing of your portfolio to pick up small relative under-valuations between asset classes. They enable you to invest when the market has experienced a larger decline. These factors combine to lower your portfolio volatility and your overall risk.
  • Confirm your risk tolerance. If you’re watching the market downturn nervously, it’s a signal to rethink your risk exposure. Take (or retake) our questionnaire and see if your portfolio’s risk level matches your current comfort with market volatility. Your portfolio should be aggressive enough to achieve the long-term returns you want, while still enabling you to be comfortable living through short-term market pullbacks.
  • Harvest tax losses. Our investment team carefully reviews market conditions for opportunities to reduce your taxes. We automatically look for conditions to lock in a lower cost-basis and capture tax losses for our clients, who can use that loss to offset other gains (and even income) to reduce their taxes. We purchase a similar asset class ETFs so our clients remain fully invested for a market rebound.

At SigFig, we work to deliver the optimal investing tools and asset management services for our clients and their portfolios in any market conditions. Choppy market waters can frighten even the most seasoned investors, but with the right tools and investment partners, even a market downturn can be an opportunity to invest better.

Aaron Gubin
Aaron Gubin leads research for SigFig’s Wealth Management team. He holds a Ph.D. in Finance and taught investments and portfolio management to graduate and undergraduate students before coming to SigFig. His research focuses on asset allocation, behavioral finance, and investment management.

The Google Stock Split

Google is creating an entirely new class of share and issuing them to shareholders as a stock dividend. On April 2, 2014, Google will avoid the typical split of simply doubling the number of existing shares (which would halve the value of each share), and instead split their stock in a rather unusual way.

Why is GOOGLE doing this?

Google is trying to protect their super-voting stock via this unusual split.

Google has three classes of stock with different voting rights on corporate events (like Board of Directors elections): Class A (1 vote each) is what has traded since the company went public; Class B (10 votes each) is primarily owned by founders and insiders; and Class C (0 votes each) is the new kid on the block being issued through the share dividend. Tip: Class C will trade under the old symbol (GOOG) going forward.

If Google did a typical split, they’d double the voting power of the A shares relative to the B shares, which would dilute the founders’ voting power. The founders don’t want that. Instead, the company is issuing the new Class C, which comes with no voting power. The way Google handled their split, the value of the two public classes (A and C) should be approximately the same, since the effective voting power of the Class A shares is virtually zero. As it stands, the company’s two founders, Larry Page and Sergey Brin, own the majority of the Class B stock and it looks to stay that way. Together they control 56% of the votes, impacting non-paltry decisions like who comprises the Board of Directors.

When companies initiate splits, it’s usually to make their shares more affordable to regular investors. Typically, when a company does a 2-for-1 stock split, they announce that for every one of your existing shares, you now own two shares. Same class of stock, they just double the number of shares that are in public hands. But each share is then worth half as much. (It’s like slicing a pie into 8 pieces instead of 4.) At $1,000 per share, Google was too expensive for many investors to buy for their portfolio. But following the split, Google share value will halve, making it more affordable.

By issuing non-voting stock, the company can make the value of each public share more affordable to everyday investors with twice as many shares available, while not changing the voting power of the founders because the new shares have no voting power.

The technicals of the transaction:

The class of shares trading on or before April 2 (known as Class A), will change their trading symbol from GOOG to GOOGL. When the markets open on April 3, these shares of stock will trade under the new, 5-letter symbol.

  • If you owned the stock on March 27, 2014, you will also receive the new class (Class C). This new class will trade under the old symbol, GOOG.
  • If you bought GOOG between March 28 and April 2, you own the Class A shares, but you will not receive the special dividend.
  • If you buy GOOG after markets open April 3, you’re buying the Class C shares.

How SigFig Portfolio accounts for this transaction:

Synced Portfolios should update automatically by their brokerages. Class A shares should list as GOOGL and the stock dividend Class C shares as GOOG. To double-check this, go to Account Settings to verify the last synced time. If your account synced on login, but your portfolio does not list the shares correctly, it is possible that brokerages haven’t yet added the shares to the synced data feed; this may take a day or two.

On Google Split Eve (April 2-3), manual portfolio users will have their tickers updated to GOOGL and SigFig automatically added an equal number of GOOG (Class C) to the manual portfolio. We tried to make it easy for most users, but a few users may have to make some adjustments.

Here’s where the split gets a little hairy in your manual portfolio:

  • If you bought Google stock between March 28 – April 2, delete GOOG to realign the value of your portfolio. You would not be entitled to the Class C stock, so your portfolio value will overstate your actual portfolio value.
  • If you owned Google stock on March 27, but sold it between March 28 – April 2, manually add GOOG to your portfolio. We did not add shares of Class C and will thus understate the value of your portfolio.
  • If you have a manually entered lot, add the appropriate date to the new GOOG holding. Your previous lot will be updated to reflect GOOGL.
  • If you have GOOG on your Watchlist, we have made no changes, so you are now following the Class C shares.

For more detail from Google’s Investor Relations, click here:

https://investor.google.com/financial/class-c.html#tab=timeline

Aaron Gubin
Aaron Gubin leads research for SigFig’s Wealth Management team. He holds a Ph.D. in Finance and taught investments and portfolio management to graduate and undergraduate students before coming to SigFig. His research focuses on asset allocation, behavioral finance, and investment management.