Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. The more different you are from the person that defined a rule the less you should follow the rule. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.

Are passive ETFs leading to lower returns?

“To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.”

- Ben Graham

Is it possible that John Bogle was wrong? Yes, that John Bogle. The legendary founder of Vanguard John Bogle. The inspiration for a legion of followers known as Bogleheads. The man whose passive revolution so stirred up the investment industry that it was once described as ‘un-American’.

If you’ve been paying attention you are probably aware that active managers have a terrible track record of beating their passive counterparts. You may have even decided that you are only investing in passive funds and ETFs. You would not be alone.

In the United States passive has received more investor inflows than active for the past nine years. Active has had net negative flows every year since 2014 except for 2021. In 2024 the total assets passively invested in the US surpassed active.

In Australia the picture is distorted by giant industry super funds who invest actively in their pre-mixed options. However, 90% of ETF assets are in index-tracking products according to Vanguard and ETFs are increasingly popular with a record $239.09 billion invested in ETFs at the end of 2024.

If you’ve made the decision to only use passive products you’ve done it because you are trying to create a better future for you and your family. That is what I’m trying to do and I’ve made the same decision. The portion of my portfolio in funds and ETFs is all passive.  If you’ve taken a similar approach you may be surprised about what I’m about to tell you. A study showed that individual investors with passive ETFs underperformed investors without them.

What is passive investing?

There is no better person to describe passive investing than Vanguard founder John Bogle. He said “The winning formula for success in investing is owning the entire stock market through an index fund, and then doing nothing. Just stay the course.”

Whatever is happening with the rise of passive investing it is not that. The first issue is that a “passive” investment is any fund or ETF that tracks an index. That index could be the S&P 500 or it could be the Nasdaq Sprott Energy Transition Materials Select Index. Yes that is a real index and yes there is a difference. In fact, there are currently 295 ‘passive’ ETFs in Australia. I have a feeling that Bogle wouldn’t think much about this technical definition and would have a much smaller list of ETFs he considered passive. Most ETFs fall well short of “owning the entire stock market.”

The second issue is that the investment industry has confused passive investments with passive investing. This isn’t surprising. The investment industry sells investments so that is what they are interested in. You should be more worried about the way you invest.

What is actually happening is not the rise of passive investing. What is happening is investors are buying passive investments and then selling passive investments to buy different passive investments. All indications are that this exchange of passive investments is happening frequently.

In a study called The Dark Side of ETFs they cite data from the Deutsche Borse that showed ETFs were traded just as frequently as stocks by 2009. This outcome was predicated by none other than….John Bogle.

In 2012 Bogle said that ETFs are “what happens when you have marketing people instead of investment fiduciaries running money. The ETF is the magic word of the day, the greatest marketing innovation of the 21st century. They are absolutely speculation, and they have hurt a lot of people.”

In 2024 41 new ETFs were launched in Australia. The marketing people have been doing a lot of work. The good news is that whatever they are doing is working as investors are clearly switching from ETF to ETF frequently.

The irony of non-passive investing using passive investments

We’ve heard from Bogle on what passive investing is and his view of ETFs. Now it is time to hear why he thought passive investing was a good idea in the first place. His advocacy for passive investing centred around low fees and better tax outcomes stemming from lower turnover.

We must admit there is a certain irony at play here. Investors who eschew active management because of underperformance, higher fees and worse tax outcomes have instead decided that they can outperform by trying to time the market using passive investments. And what do they get from market timing? Underperformance, higher transaction costs and worse tax outcomes.

I have a theory why. We spend most of our lives trying to avoid being seen as average. We all suffer from the Lake Wobegon effect “….where all the women are strong, all the men good-looking, and all the children are above average.” Over 80% of people believe they are above average drivers. 94% of university professors say they’re above average as instructors. When two partners are asked how much they contribute to household chores the total adds up to 120% of the actual work being done.

We will do anything to maintain this aura of superiority. We lie to others to not be seen as average. More significantly we lie to ourselves. This is known as the Dunning-Kruger effect which is a cognitive bias that blinds us to our own deficiencies. It occurs because when we aren’t good at something it is generally because we don’t know enough about what we are doing. And because we don’t know enough about what we are doing we can’t figure out we aren’t good at it.

Passive investing is settling for average. When we combine our attempts at trying not to be average with our overestimation of our investing ability it leads to poor results.  This gets back to the Ben Graham quote at the beginning of the article. He said this before the birth of passive investing but his point stands. Satisfactory results aren’t that hard to achieve and getting superior results is a lot harder than it looks. Satisfactory results are likely good enough.

Simply getting the index return – or being average – would allow most investors to achieve their goals. Shares have delivered remarkable returns over the long-term which are far higher than most professional and individual investors end up getting. Professor French at Dartmouth did a study that indicated that the typical investor would increase average annual returns by 0.67% over the 1980-2006 period by investing passively in the way Bogle defined it.  

It is the striving for superior results that is the problem. We buy speculative investments and we try to time the market while trading too much. In the case of investors with ‘passive’ investment it is the market timing that is the issue. That is what the study I referenced at the beginning of the article shows. In this case we are undone not by security selection but by timing which is exacerbated by using passive investments. I will quote from the authors of The Dark Side of ETFs:

“We conclude from the above results that poor market timing and not poor security selection is responsible for the performance deterioration experienced by the users of index linked securities like ETFs. The more interesting result is that the tests show that users of index-linked securities worsen their market timing ability by using these products. The reason must be that users employ these easy-to-trade index-linked securities that are highly correlated with the market to make bets on market phases, and they bet wrong.”

Final thoughts

I’m not a passive investor. I hold individual shares and the ETFs I own are a mix between broad index ETFs like Bogle advocated for and factor ETFs that are oriented towards income. Yet despite the investments in my portfolio I'm a lot more passive than most investors. I've tried to apply the lessons I’ve outlined in this article to minimise trading and therefore reduce my taxes and transaction costs. I don’t try and time the market and consciously reject all the justifications for doing so.  

Nobody is intentionally sabotaging their returns. Each of us is just trying to do the best we can to improve our results. The biggest problem is that most investors don’t know what it takes to be successful. We are bombarded with messages to do something - buy this new ETF, take advantage of this brilliant insight. We want to seem smart by not just sitting on our hands. We want to take control of our outcomes by being proactive and succumbing to our action bias. We don’t want to be average.

I’ll turn to Bogle once again for some parting words:

“While the interests of the business are served by the aphorism 'Don't just stand there. Do something!' the interests of investors are served by an approach that is its diametrical opposite: 'Don't do something. Just stand there!’”

Please share any thoughts or topic suggestions with me at [email protected]  

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Read more of Mark's articles

Previous editions of Unconventional wisdom:

  • Unconventional wisdom: A controversial income pick
  • Unconventional wisdom: The not so inevitable investment case for AI
  • Unconventional wisdom: Don’t play Russian Roulette with your finances
  • Unconventional wisdom: 3 things you won't find in my portfolio
  • Unconventional wisdom: A simple way to better returns

What I've been eating

It has been very hot in Sydney but sometimes you just need ramen. Ramen originated in Chinatown in Yokohama in the early 1900s but didn’t gain widespread popularity until after World War II. Many of the Chinese settlers in Yokohama were from Guangdong and Jiangnan and ramen is derived from southern Chinese noodle-based dishes. I recently returned to Gogyo in Surry Hills where they make a unique ramen called Kogashi or charred ramen. Below is the Kogashi Shoyu which involves charring the soy sauce for 30 seconds in pork lard heated to 320 Celsius. That charring process accounts for the unique colour and flavour.

Ramen