Tag Archives: passive

Passive Over Active Investing

In the investment world, there is an ongoing dispute over passive investing. Basically, the evidence shows that passive investing (through index investing) out-performs active investing. This is one of Burton G. Malkiel’s main arguments in “A Random Walk Down Wallstreet.” He famously claims that “a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do just as well as one selected by the experts” (pg. 26). As Professor Kimball has also reiterated numerous times, getting rich in the stock market by carefully selecting specific stock, is simply a matter of luck. This is the basis for Malkiel’s claim that index investing is the best way to go.

First, it is important to understand exactly what index investing is. As defined by Investopedia, an index fund is “a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.” Index funds are known for having low costs and for being handled passively, meaning there is no active management like in active stock portfolios. Here is where financial advisors come in. The argument behind whether indexing is a better strategy is mostly alive because advisors benefit from charging high fees when managing active portfolios. They do not benefit from suggesting to clients to invest by indexing, because they gain lower fees from doing so.

And as Malkiel (as well as Professor Kimball) likes to point out, financial advisors who claim to be able to make you enormously rich in the stock market, following their pretty formulas, are full of it. Of course, there is a basic science to it: buy low, sell high. But besides this, it is pretty much up in the air. An article in Forbes does a nice job of explaining the benefits of indexing, and the lies told by advisors about it: “exhaustive academic studies covering the active versus passive debate going back many decades…ends with the same conclusion; while a handful of active managers beat their benchmarks due to skill, it wasn’t by much, and most didn’t sustain that benchmark-beating performance for long. In addition, it’s not possible to determine luck from skill or to pick skilled managers in advance.” It is interesting that the author acknowledged that skill may be a factor, but then states it is impossible to differentiate between skill and luck. Indeed some people are probably very skilled in managing active investments, but the likelihood of finding an advisor like this is so low that it is not worth the trouble. Either way, if you were to find such an advisor (like was pointed out) it is impossible to know the difference between luck and skill. Unless, of course, you are willing to trust in their luck.

The five lies outlined as being frequently used by advisors in order to sway investors away from indexing are the following:

1. Active US stock funds beat the market over the past decade.

2. Index funds will always achieve below average returns.

3. Indexing doesn’t work in inefficient markets such as small cap or international

4. Active managers perform better in bear markets

5. Warren Buffett has beaten the market and this proves indexing doesn’t work

I encourage you to read the reasoning behind recognizing these claims as lies. For the sake of longevity, I won’t get into them. But it isn’t so hard to understand the concept. And it makes sense that active investing is encouraged by those who benefit from high fees (advisors). It seems that the only reason for this argument to even be an argument, and not a fact, is that there is a clear conflict of interest with those involved. Finally, I’d like to point out that I have nothing against advisors, and I plan to go into the field myself. But I certainly think there are better ways to perform this service, that doesn’t involve deceiving clients in matters like this one.

Why do people use active managers?

activepassive

The question about whether to use active managers or passive managers when it comes to the stock and bond markets is one that has been discussed over and over on out class blog.  A few weeks ago, I wrote about how some managers thought this was a good year for stock picking due to lower market correlation.  Such theories have no statistical weight behind them; most active managers are outperformed by simple index funds each year, even before their higher management fee are considered.  Despite the superior performance of passively managed funds, more people use active funds than passive funds.  While I think the active versus passive question has been thoroughly settled, not as much discussion has taken place about why people use actively managed funds.  This blog will provide a few theories for why people use actively managed funds rather than passively managed funds.

  1. Ignorance/Fear: The average American probably knows very little about the stock market and how it works.  Sure, many people track the DJIA or S&P500 and perhaps know how the market is doing on aggregate, but that doesn’t really qualify as understanding the market.  Thus, when they do want to invest their money into the stock market they feel like they have no other option than turning to the professionals for fear of losing everything that they invest.  These professionals, probably seeking a management fee for themselves, point them to an actively managed fund.
  2. Clever Marketing: Investment firms certainly work to perpetuate the idea that investing in the stock market requires a professional.  Such an idea is critically important for the health of their business. Every firm likes to tout how they beat their Lipper averages, which are a comparison to similar investments.  Unfortunately, comparing an actively managed fund to other actively managed funds doesn’t tell an investor anything about how well they do relative to other types of investment vehicles.  Especially with a market in 2013 where everyone brought in huge returns, brokers could easily advertise that their funds gained 25% in 2013, without their clients knowing they lost to the market by 7%
  3. People are willing to take the risk for higher return: Both Burton Mankiel and Professor Kimball recommended Vanguard Group for low cost index funds.  In fact, Vanguard invented the index mutual fund!  But even Vanguard offers actively managed funds in additional to passive index mutual funds.  They admit that, “while Vanguard believes there’s a very persuasive argument for index investing, that argument doesn’t rule out well-executed active management at a reasonable price.”  Some people may know that index funds generally outperform active funds, but they may be willing to take the risk that their active fund manager will hit it big one year.
  4. Not all markets are equally efficient: As a recent WSJ article suggests, some people believe that only some markets are efficient.  Namely, markets with extremely high volumes, like large cap companies and bond markets are generally quite efficient.  In recent years, even emerging markets have become quite efficient.  But some investors question whether smaller markets like small cap stocks might still leave opportunities to find undervalued stocks.  I personally believe that this theory may have a grain of truth behind it.

There is also one more important thing to consider: passive funds need active funds.  If everyone just bought stock indices and then did nothing, the market wouldn’t react to economic changes, and then would hardly produce any returns at all.  In order for a stock price to go up, there must be active managers willing to be a stock at a higher price than what the price is currently .