At a time when our political landscape is as divisive and contentious as it has ever been, it should come as no surprise that the active versus passive debate in investment circles mirrors the broader decampment into “Us” and “Them.”
But if there is one benefit to all this dissension, it is that deeply held assumptions are being examined and light is being shone in the dark corners of an industry that has tended to privilege self-preservation over serving clients. In this article, I offer my critique of both active and passive investment management as they have traditionally been construed and offer suggestions for a third way. For a deeper understanding of my beef with the two-party political system, you will have to buy me dinner.
Passive Tends to Be Less Expensive and Better Performing, But Has Its Weaknesses
Critiquing passive management is a bit like telling someone that their baby is ugly; it’s unlikely to change any minds and less likely to win you any friends. From a philosophical standpoint, passive management is rooted in a belief in the efficient market hypothesis (EMH). The EMH states that markets quickly and efficiently incorporate all relevant information into prices, making stock-picking an effort in futility. After all, if the price is always right, why bother doing any further research?
Behavioral investors recognize that history tells another story about price dislocations—one that is subtle but meaningful. As Warren Buffett said of efficient market theory (EMT) in his 1988 Berkshire Hathaway letter to shareholders:
“The doctrine [EMT] became highly fashionable—indeed, almost holy scripture in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. Amazingly, EMT was embraced not only by academics, but also by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.”
Since passive management eschews costly research and rock-star managers, passive vehicles tend to be far less expensive than their active brethren, which is a huge win for investors. All else being equal, investors should always choose the least expensive fund, as fees cut directly into performance and can dramatically reduce compounding over a lifetime.
What’s more, passive funds are not just inexpensive, they have consistently spanked active funds over just about any time frame you’d care to consider. Just look at the results of S&P Dow Jones Indices’ SPIVA U.S. Scorecard, a comparison of how active managers have done relative to their passive counterparts. Over five- and 10-year periods ending in December 2015, 84% and 82%, respectively, of large-capitalization money managers were beaten by passive approaches to investing (and that’s before their fees!). The results for small-capitalization stocks, often considered to be less efficiently priced and therefore more favorable to active management, are just as damning: 88% of small-cap managers were bested by passive approaches over the past 10 years.
With miniscule fees and impressive returns, it’s no wonder that investors from Warren Buffett on down recommend passive vehicles as the best choice for most individual investors. Are there weaknesses to this sensible approach? Yup, there are.
A Faulty Framework
Just as an architectural structure is only as sound as the foundation upon which it is built, an approach to investing can be no better than the ideas that undergird it. In the case of the efficient market hypothesis, that foundation is shaky at best.
One of the central notions of EMT—the price is always right—has proven laughably false over the course of recorded financial history. Over 400 years ago, in what is one of the first recorded bubbles in financial history, a single commodity traded for 10 times the annual salary of a skilled laborer. Records from that time show that this commodity was traded in some cases for as much as 12 acres of prime farmland and even swapped directly for single-family dwellings. What was this precious commodity, you ask? A single tulip bulb.
But prices becoming grossly disconnected from fundamental value is not some ancient construct that modern man has outgrown. As recently as 1998, eToys, an internet start-up company, had a total market capitalization of $8 billion on sales of $30 million and losses of $28.6 million. Its closest competitor, the “stodgy” veteran Toys“R”Us, had sales more than 40 times greater and was profitable, but had only three-quarters the market capitalization, as I and Chuck Widger discussed in the book “Personal Benchmark” (John Wiley & Sons, 2014).
The reason for this huge discrepancy was investor enthusiasm over the then-new internet. Of course, Toys“R”Us also had a website for selling toys, but manic investors were unable to see past the seemingly unlimited profits promised by the new batch of online start-ups. In this euphoric state, traditional metrics like sales and profitability were ignored in favor of vague hopes—only for those hopes to be dashed on the rocks of cold economic realities. eToys went bankrupt toward the end of the tech bubble and was acquired by—you guessed it—Toys“R”Us in 2009.
Inasmuch as one of the foundational assumptions of EMT is demonstrably false, it stands to reason that an investment discipline built upon this assumption can be improved upon. Jim Grant, the publisher of Grant’s Interest Rate Observer, said it far more interestingly: “To suppose that the value of a stock is determined purely by earnings is to forget that people have burned witches.”
Passive Investing Isn’t, Well, Passive
To listen to some of the most devoted adherents of passive management, one might assume that the indexes tracked by these investors were the product of some inviolable process. The dirty little secret of a passive index like the S&P 500 is that it’s not, well, passive at all. The stated mandate of the Standard and Poor’s methodology is to choose a basket of stocks that reflects the broader U.S. economy by including “leading companies in leading industries.” Rob Arnott describes their methods in his book “The Fundamental Index” (John Wiley & Sons, 2008):
“The process is subjective—not entirely rules-based and certainly not formulaic. There are many who argue that the S&P 500 isn’t an index at all: It’s an actively managed portfolio selected by a committee—whose very membership is a closely guarded secret!—and has shown a stark growth bias throughout its recent history of additions and deletions.… The result is that the Standard and Poor’s is predisposed to add ‘popular’ stocks and those that have performed well recently, rather than those with potential to improve on recent poor results.”
Simply put, financial indexes are a product of active human intervention and, as such, are prone to all of the biases that beset regular investors.
To illustrate the damaging effects of this subjectivity, Arnott discusses some of the changes made to the index in recent years. In 1995, 33 additions were made to the S&P 500, with a scant four of these additions being drawn from the tech-heavy NASDAQ index. In 2000, however, at the height of the tech craze, 24 of the 58 companies added to the S&P 500 were tech issues from the NASDAQ. In addition, the committee bypassed what few bylaws it did have for inclusion to allow for the addition of popular but unprofitable companies like America Online. By ignoring their sensible rules, the S&P 500 committee actively loaded the boat on their “passive” index just in time for catastrophic losses in the tech stocks they had just added.
The result of this hubris on the part of the committee seriously damaged everyday investors. From March 2000 to March 2002, the average stock gained 20%, while the now-tech-heavy S&P lost 20%. A secretly appointed committee adding stocks to a portfolio with few governing rules does not look much different in practice than a mutual fund manager making additions based on similarly loose logic. For this reason, passive investment vehicles may not be as passive as you’d imagine and may subject you to all of the same return-chasing behavior present in nominally active approaches.
A Behavioral Glitch
Ask anyone on the street the one thing that they know about investing and they are likely to blithely say, “Buy low, sell high.” The primary problem with passive investing is that it systematically violates this very first rule. Passive indexes are capitalization-weighted, meaning that the larger the total value of a company’s stock, the larger a portion of the index they represent. As Rob Arnott says, “the capitalization-weighted implementation of the index fund concept is flawed. Because the size of our investment in any company is linked to stock prices, the capitalization-weighted portfolio overweights the overvalued stocks and underweights the undervalued stocks.”
It is just as stocks get more expensive, and thus less attractive to buy, that their power within an index grows. Simultaneously, stocks that have been beaten down and may present excellent buying opportunities have diminished power. In a very real sense, index investing locks in the exact opposite of what we ought to be doing and causes us to buy high and sell low.
Index investing, widely considered to be the sensible approach for individual investors, has at its nucleus a damaging behavioral cancer. Buying a capitalization-weighted index like the S&P 500 means that you would have held nearly 50% in tech stocks in 2000 and nearly 40% in financials in 2008. Just as surely as indexing combats some behavioral tendencies—like underdiversification and overpaying—it makes others law.
A behavioral approach to investing must hold on to the best of indexing—and there is much to emulate—but must also improve upon indexing’s tendency to load the boat with large, expensive stocks, which are historically some of the worst performers of all.
The Unfulfilled Promise of Active Investing
Much like smoking or eating processed meat, actively managing money has experienced a reputational decline over the last 25 or so years. While some of this is unfair (endless hand-wringing about high-frequency trading, for example), active management has done much to earn its bad reputation. If index investing is designed to mirror a market benchmark, active investing can simply be thought of as an investment style that seeks to outperform a representative market benchmark. The ostensible benefit of an active approach is that it has the potential to both outperform and manage risk, but while some active managers have lived up to this dual mandate, many have not.
The damning truth about active management is that it’s a zero-sum game before fees, meaning that active efforts are ultimately reductive. Just as the average record of every major league baseball team will always be .500, the average performance of active managers will always be, well, average—and that’s before the fees. This line of reasoning is often heard from detractors of active management, who will smugly assert, “It’s just math.”
But as Arnott says in “The Fundamental Index”: “The fact that active managers haven’t been able to exploit pricing errors for above-benchmark performance does not provide any evidence that those errors are small, because the average results of the average active manager are a foregone conclusion.” Just as the collective mediocrity of baseball teams doesn’t make watching baseball any less enjoyable—and one team does win the World Series every year—so too mustn’t the collective mediocrity of asset managers be the only reason we choose to invest in a particular way. The structural difficulties of outperformance say everything about the group, but nothing about any manager in particular—a good thing to keep in mind the next time you hear, “It’s just math.”
The asset manager attempting to achieve outsized performance begins with a significant handicap in the form of trading fees and management costs. After all, Harvard Ph.D.s in financial engineering don’t work for free! As cited in “The Fundamental Index,” the impact of these two obstacles is dramatic, accounting for between 0.5% and 2% annual underperformance for active managers. A mere 2% may not sound like much, but realize that an investment of $100,000 that compounds at 10% a year will grow to $1.7 million over 30 years, whereas that same investment compounded minus 2% in fees grows to just $1 million over that same time frame.
Another source of disruption is that many active managers close up shop every year and may not be reported in performance figures. A 2000 study by Arnott, Andrew Berkin and Jia Ye (“How Well Have Taxable Investors Been Served in the 1980s and 1990s?,” First Quadrant Perspective) shows that when the failed funds are included in performance figures, the underperformance of active funds may be as dramatic as 2% to 4% per year. To revisit our example, a return of 6% a year (10% return, less 4% underperformance per year) yields a mere $574,000—quite a price to pay! The behavioral investor understands the corrosive power of fees and trading costs and must seek to minimize both wherever possible (Figure 1).
Few investors would begrudge active managers their paycheck if they showed evidence of discipline and skill, but the research suggests that professionals are just as prone to making boneheaded mistakes as you or I. Charles Ellis points out, in “The Elements of Investing” (John Wiley & Sons, 2012), “professionally managed funds tend to have their lowest cash positions at market tops and highest cash positions at market bottoms.” Just like us, they greedily load up when stocks are expensive and sell in panic when stocks become attractively priced. Thanks for nothing, money managers.
What’s more, the research even suggests that it is difficult to choose which money managers will do well. In the book “The Investor’s Paradox” (Palgrave McMillan, 2014), Brian Portnoy, Ph.D., cites evidence showing that only 5% of professional fund of fund managers show discernible skill at their jobs. If people who are paid handsomely to select winning money managers are unable to do so, what chance do you have of doing likewise? The lessons for behavioral investors are unavoidable: You must automate your process wherever possible and avoid bias in the selection of people and processes. To do otherwise is to believe that professional money managers are actually above the fray of human bias, when the evidence shows us otherwise.
Active managers have of late been quick to scapegoat the broader environment—accommodative Federal Reserve policies, recovering from the throes of a deep recession—but the fact is that the trends discussed above are pervasive and long-standing. As Jason Zweig of The Wall Street Journal says on his website (JasonZweig.com):
“Despite what you’ve heard and what many of you fervently believe, underperformance is not merely a temporary by-product of the narrow market of the past few years. Over the decade ended in mid-1974, 89% of all money managers lagged the S&P 500. Over the 20 years ended in 1964, the average fund underperformed by roughly 110 basis points. Even from 1929 through 1950, not a single major mutual fund beat the S&P. Take any period you like; the results are invariably discouraging.”
The simple fact is that, as a whole, active money managers have not done their job for some time now—the SPIVA scorecard shows that 83% of domestic equity managers have underperformed passive benchmarks over 10-year period ending December 2015. They have overtraded, charged excessive fees, fallen prey to emotional traps and have not differentiated themselves meaningfully from passive approaches. If active management is to survive, it must do so on its potential merits—risk management, performance, accounting for behavioral bias—and not on false promises.
A Third Way?
As a result of the trends discussed here, the investment industry is becoming increasingly divided between advocates of what have traditionally been considered active and passive investing. But as we have seen, both have their strengths and weaknesses. Active management provides the hope of outsized performance and managed risk, whereas indexing has lower fees and tends to have lower turnover. Inasmuch as all investing is active, indexing included (aside from true global capitalization-weighting), it makes more sense to discuss what works and what doesn’t—relentlessly exploiting every edge at our disposal—rather than engage in semantic bickering.
Investment vehicles that perform well have tended to have the following characteristics: diversified, low turnover, low fee and allowances made for behavioral bias. Investing that doesn’t work is just the opposite: expensive, undiversified, frequently traded and fails to account for bad behavior. By blending the best parts and removing the worst parts of these two schools of thought, we can achieve a moderately priced option that accounts for investor behavior, minimizes transaction costs and seeks to outperform the broad market.
Active approaches can be improved upon by limiting manager bias, ensuring meaningful differentiation from a benchmark (i.e., no “closet indexing”), decreasing transaction costs and lowering fees. Passive approaches can be improved by taking a rule-based approach to portfolio construction and by eschewing factors that inhibit performance (e.g., large size) for considerations that have historically contributed to performance. While a detailed description of how to construct such a portfolio goes well beyond the space limitations we have here, it seems reasonable to suggest that a rule-based behavioral portfolio would meet the following four Cs:
Consistency: Frees us from the pull of ego, emotion and loss aversion, while focusing our efforts on uniform execution.
Clarity: Prioritizes evidence-based factors and keeps us from being pulled down the seductive path of worrying about the frightening but unlikely or the exciting but useless.
Courageousness: Automates the process of contrarianism, which is doing what the brain knows to be best but the heart and stomach have trouble accomplishing.
Conviction: Helps us walk the line between hubris and fear by creating portfolios that are diverse enough to be humble and focused enough to offer a shot at long-term outperformance.
Embarking on a program of rule-based behavioral investing requires intellectual concessions from both passive and active devotees. For active believers, it requires the humility to understand that simple rules tend to outperform human discretion. For passive acolytes, it requires the recognition that all investing is active and that the core assumptions of indexing can be improved upon.
In the future, it is my hope that we will worry less about whether or not an investment style is active or passive and more about whether or not it is evidence-based. My study of investor psychology tells me that I should own a rule-based basket of high-quality, attractively priced stocks in sufficient numbers to diversify business risk, but in a concentrated enough way to improve potential performance.