We have all heard some form of the claim “There are two kinds of people in this world…” And sure enough, the investing world can be conveniently divided into two kinds of people: active investors, who have been around from the beginning, and passive investors, who are a relatively new species.
Wall Street brokerage houses were built on the excitement of trading and the idea that a professional manager should be well paid to pick the best stocks and outsmart the ups and downs of the market. This is known as active investing, and from the late 18th century until relatively recently, this was the “truth” of Wall Street.
But in the 1950s and ’60s, some fringe economists suggested that perhaps these professional investors were not actually performing better than a simpler strategy that merely owns the entire stock market. In 1976, John Bogle, the founder of Vanguard Group, created the first mutual fund to test this preposterous idea, and passive investing was born.
Ridicule
At first blush, the concept of passive investing is ridiculous. It was first formalized in 1970 by Eugene Fama’s efficient market hypothesis, which proposes that all relevant information is immediately reflected in asset prices, and it is therefore impossible to use this information to consistently outperform the market as a whole.
That seems ludicrous. Professional fund managers skill and expertise, not to mention better access to data, so of course they must be able to perform better than the market. The very term “passive” has a negative connotation; it implies submissiveness and a lack of initiative. Passive investing was ridiculed as simplistic and lazy, inherently un-American.
Opposition
But the active camp was missing the point. While it is true that professional managers are skilled, they do not use their skills against naïve amateurs. They use them to compete against each other. And as they compete, costs are incurred from trading, information systems, distribution, and their own generous compensation, which, of course, passive investors do not have to pay. As the appeal of low-cost passive investing gained traction, and as the evidence began to show that it does usually outperform active investing, the opposition became quite heated.
After all, passive investing was – and is – a threat to the vested interests of active money managers. Experts who had built their careers and lucrative business models on claims of superior knowledge and skill were faced with the fact that, simply because of their higher costs, active managers had to, on average, underperform the passive variety.
Then the tone of the opposition began to change. Of course, the average professional manager will underperform a passive strategy; that is why it is imperative to pick a professional who is above average. The problem with this line of argument is that above-average performance rarely persists from year to year. According to a study by Dimensional Fund Advisors, if a US equity manager was in the top quartile of performance over any previous five-year period, the odds of that manager being in the top quartile over the next five years is just 22%. Given that any manager has 25% odds of being in the top quartile just by chance, it is likely that any outperformance we see is due to luck rather than skill.
Acceptance
In recent years, the data in favor of passive investing has become overwhelming, and it now seems almost self-evident if you understand how markets work. Because market prices tend to immediately reflect all relevant information about a particular security, an active manager does not just have to gain an advantage over some other investors to consistently out perform the market – they have to gain an advantage over the market itself, which represents the sum total of the knowledge of all investors. The odds of an active manager winning this game in the long run are quite low.
The recent acceptance of passive investing as a valid method is clearly demonstrated by the flow of investor money into passively managed funds and away from the active variety. The precise magnitude of the transition is difficult to measure, but it is estimated that the exodus out of active funds has totaled $2 trillion to $3 trillion over the past ten years. Yes, trillion.
The Evolution Of Truth
Now that the once-ridiculous notion of passive investing has been widely accepted as valid, it is the active managers who are sometimes viewed as ridiculous. Despite the evidence sup-porting passive investing and the recent flow of assets toward the passive approach, a majority of investor assets are still actively managed. Why is this so?
The reason is probably twofold. The first factor is marketing. Actively managed funds, with their higher fees, are far more lucrative for Wall Street than are passive funds. Thus, there is a strong financial incentive to tout the recent out performance of the latest star manager, even though that performance is unlikely to persist.
The second factor is human nature. Active management has an appeal similar to that of a casino – trading is exciting, and the possibility of making a lot of money quickly is always there. Plus, the allure of a speculative strategy fits perfectly with the vested interests of Wall Street, so the persistent popularity of active investing is not terribly surprising.
So, a colorful debate continues. Rex Sinquefield, co-founder of Dimensional Fund Advisors and a supporter of passive investing, asked, “So who still believes markets don’t work? Apparently it is only the North Koreans, the Cubans, and the active managers.” The active camp stands in stark contrast. Alliance Bernstein analyst Inigo Fraser-Jenkins claimed that passive investing is “worse for society than Marxism.” The two sides agree that Marxism is a bad idea, but the common ground ends there.
The irony is that if all investors were passive, no one would be doing any research, and it would be easy to beat the market with an active strategy. With more and more assets moving into passive strategies, we may someday find ourselves asking how far we have to go down the road of passive investing before the superiority of active management, which seems ridiculous now, is once again regarded as true.
