Active vs. Passive Investing

This is the first of two posts on this subject.  Here I want to tackle why understanding this debate is not just relevant but crucial to all investors.  In the follow-on post I will ask you to rethink whether active vs. passive is really the debate we should be having!

Executive summary:  The only people who should be paying for actively managed strategies is…no one.  The likelihood that you will perform well enough to cover costs is so low it’s not worth trying, and the opportunity cost of doing so makes the gamble nonsensical.  Be smart and invest using passive tools.

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For those who may not have an ear to this debate, the discussion about whether active investing (trying to beat the market via smart security selection) is superior to passive investing (trying to mimic the market return by investing in index-based strategies) is becoming deafeningly loud.  The flow of assets out of actively managed strategies is accelerating at the same time passive strategies are gaining more and more market share.  It seems every day there is another article in the mainstream media about this subject, with folks on either side of the debate arguing their case with an almost religious fervor.

Clearly there’s a lot at stake for both sides.  From an economic standpoint, active management has billions to lose annually if investors decide their approach is worthless.  The amount of money made by those on the active side is jaw-dropping and that all goes away if the wizard no longer has any clothes.  Well, folks, I’m here to tell you that the wizard better be wearing sunscreen, because he’s naked as a jaybird.  And if the wizard is as unclothed as I’m saying, why then do we need all those folks doing all that “work” that serves no purpose?  Quite simply, we don’t, and so they’ve dug in and are fighting tooth and nail to save their precious jobs and massive incomes.

Don’t worry, I won’t take you through the mountain of research that undresses the wizard of active management.  It’s out there for all to see in the dozens of books, hundreds of peer-reviewed research papers, and thousands of articles dating back many years and if you are truly interested I’m happy to direct you to the best of it.  But I do want to offer a few bits of information for the doubters to chew on so that perhaps they might begin to rethink what they’ve taken for granted all these years:

  • In each of the last 1, 3, 5, 10, and 15 year periods, well over half of actively managed funds failed to beat their appropriate indices (SPIVA U.S. Year-End 2016 Scorecard);
  • Most compelling are the 15 year numbers where in some categories of US stock funds, practically ALL (99.43% of small-cap growth) funds were beaten by their index and the best performing category saw only 21% of its funds able to beat the index (large-cap value);
  • Underperformance is pervasive across asset classes and geographies, so the argument that there are certain “inefficient” markets in which active does better is simply not true;
  • More than half of most active fund categories are either merged with another fund or liquidated (usually due to poor performance, lack of investor interest, or both) into another fund by the 15th year, meaning it’s a coin flip as to whether the active funds you hold today will be around later;
  • It’s been shown that true investment skill is extremely rare – most of the limited outperformance over any period is due to luck.  A famous paper from 2010 showed that only managers in the top two percentiles of performance evidenced a statistically significant amount of skill;
  • Outperformance that we do observe in one period is highly unlikely to persist into the next period…less likely than one would expect by chance alone (S&P Persistence Scorecard);
  • Because active managers as a whole have such poor performance numbers, the more active strategies in a portfolio the lower its chance to match the broad market.  One study by Larry Martin of State Street Global Advisors and highlighted in Rick Ferri’s book, The Power of Passive Investing, shows that a portfolio with 5 active strategies in it has only a 4% chance of outperforming after 10 years and only a 1% chance after 20 years…more strategies and those numbers go lower;
  • And while I’m not one to tout the opinions of gurus, it’s hard to ignore a few experts who know a thing or two and have come out in favor of passive: Nobel laureates such as Gene Fama, Dan Kahneman, Bob Merton, Myron Scholes, and Bill Sharpe; notable active investors such as Yale’s endowment chief David Swensen, Fidelity Magellan superstar Peter Lynch, and the king of active investing himself, Warren Buffett.

To me it all comes down to siding with the evidence rather than with the self-interested investment folks who are trying to keep their gravy train alive.  As Upton Sinclair once said, “It’s difficult to get a man to understand something when his salary depends on his not understanding it.”  I can’t understand why those who have heard these facts, and independently confirmed their truth, would ever invest any other way…unless, of course, their well-heeled lifestyles depend upon it!

The implications for investors are huge.  By one estimate, only 15% of regular investors’ assets are invested in passive strategies, so a whopping 85% are still focused on what has been called “the loser’s game.”  So not only are those assets invested in strategies that have a scary low chance of keeping up with the broad markets, those investors continue to pay those managers for underperforming.  The opportunity cost to investors is estimated to be in the tens of billions of dollars annually.

I’m not saying you should run out and sell your actively managed strategies, but you should definitely consider it after factoring in the tax costs of changing.  And I’m not saying you should fire the “advisor” who put you in all that junk, as you may be as much to blame as s/he is, but you should definitely question whether it makes sense to pay someone who either faces serious conflicts of interest, is ignorant of reality, or both.  And I’m not saying you should just give all your money to Vanguard to manage as there are shortcomings to that idea, too, but you could certainly do much worse.

Before you do anything, though, read my next post where I will discuss why active vs. passive is a false dichotomy.

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