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Passive Investing and Disruption

Passive Investing and Disruption

By Hamish Douglass

There appears to be an accelerating trend towards low-cost index or passive investing. 

The father of low-cost index investing, Jack Bogle, deserves the investment equivalent of a sainthood as he has commoditised buying the market index at a very low cost. Bogle is a hero of mine for the service he has done for society by lowering the cost of accessing the market index to negligible levels. I have named the office adjacent to my desk (open plan) the “Bogle room” in honor of Jack. It serves to remind me that we are here to serve our clients and, as active managers, we must do something fundamentally different, rather than mimic or closely follow the market index. 

It is important for investors to understand what they are buying when they invest in an index fund. They are buying all the constituent companies in the index. If, for example, investors buy an S&P 500 Index fund, they are gaining an exposure to 500 of the largest US companies, which represent about 80% of the market capitalisation of all companies listed in the US. Over time, the S&P 500 Index, on average, will produce a return approximately equal to the underlying earnings growth of all companies in the index, plus the dividends paid by all companies in the index, less the negative return of companies that fail, less the fees charged by the index provider. To earn reliable absolute returns from tracking a market index, the following factors must hold: 

Over the long term, the long-term price/earnings multiple remains fairly constant for the vast majority of companies in the index; and 

The failure rate of companies in the index remains fairly static. 

Historically, these premises have held for the major market indices and investors have achieved satisfactory returns from index investing.

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