Passive Strengths Copy

Even for wealthy investors, passive holdings have a strong appeal, says Christopher C. Geczy, Wharton adjunct professor of finance and academic director of the Wharton Wealth Management Initiative. “The big issue still applies,” he says. “That’s the issue of whether you believe in trying to beat the market or whether you believe in [minimizing] costs. Some of the most successful entrepreneurs I know think about costs.”

Passive, or index-style investments, buy and hold the stocks or bonds in a market index such as the Standard & Poor’s 500 or the Dow Jones Industrial Average. A vast array of indexed mutual funds and exchange-traded funds track the broad market as well as narrower sectors such as small-company stocks, foreign stocks and bonds, and stocks in specific industries.

Among the benefits of passive investing, say Geczy and others:

• Very low fees – since there is no need to analyze securities in the index
• Good transparency – because investors know at all times what stocks or bonds an indexed investment contains
• Tax efficiency – because the index fund’s buy-and-hold style does not trigger large annual capital gains tax.

Actively managed investments charge larger fees to pay for the extensive research and analysis required to beat index returns. But although many managers succeed in this goal each year, few are able to beat the markets consistently, Wharton faculty members say.

Over a recent 10-year period, active mutual fund managers’ returns trailed passive funds consistently, says Kent Smetters, professor of business economics at Wharton.

On an after-tax basis, managers of stock funds for large- and mid-sized companies produced lower returns than their index-style competitors 97% of the time, while managers of small-cap stocks trailed 77% of the time.