Monthly Archives: February 2014

Random Thoughts on Passive Investing

I am an active investor.  I am not a passive investor.  A passive investor is one who buys “the market” or some other kind of “index fund.”  The premise behind passive investing assumes that because the “average” mutual fund does not consistently beat the market, one should avoid paying mutual fund fees and simply buy low-expense index funds and exchange-traded funds (ETFs).  Active investors believe that through hard work, discipline, creativity, experience and curiosity, one can beat the market, consistently, over time.

The debate over passive versus active investing has been raging for decades.  The real issue preventing a definitive conclusion is that measuring the performance of the two approaches is nearly impossible.  When I say “nearly impossible” I mean that anyone can use the historical data to convincingly support either side of the debate.

Here is one great example:

 

 

Clearly, the author of this graphic is pro-passive investing.  These numbers are convincing.  One look at these data would be enough to force an investor out of actively managed funds straight into the arms of passive vehicles.  Only when one looks at the source of this data does the bias presented here become clear.  These returns represent a six-month period in 2011, a timeframe when most active investors (including me) struggled mightily to beat the S&P 500.  Is it reasonable to use this extremely short period of time to settle the issue of passive versus active?  I think not.

So how many years of data should one use to tackle this debate?  Five? Ten?  Thirty-eight?  Because the markets are so complex and dynamic, one can find periods, even longish periods, where one approach seems to work better than the other.  Thus, many of the studies I read which attempt to settle this issue can be subject to a timeframe bias.

Another difficulty I see in broaching this issue is defining active investing.  An index fund is designed to track the market and charge a lower fee than the average mutual fund.  Some mutual funds have shown the propensity to “closet index;” that is, they claim active management, but tend to invest much closer to the index than one might expect.  These funds enjoy higher fees than a true index fund, and because they only marginally differ from the index they are unlikely to ever show massive underperformance.  They are equally likely to never show significant, consistent outperformance.  There has been a trend over time for many mutual funds to drift this way.  Herein lies the measurement issue – are these funds “active” or “passive?”  No active mutual fund portfolio manager would ever admit to being a “closet indexer.”  Hence, all of these funds, which have grown as a percentage of the total universe of mutual funds, would be lumped into the “active” bucket for comparative analysis.  The fact that many of the “active managers” in the studies look and act like passive investors can only lead to more confusion about which approach is better.

Into this debate steps Antti Petajisto, who at the time he published his research in the July/August edition of the Financial Analysts Journal was a professor at the NYU Stern School of Business.  He looked at thousands of mutual funds over the 1980 to 2009 period and made the following conclusions:

a) Three broad styles of “active investing,” namely, “closet indexers,” top-down macro investors and concentrated stock pickers – underperformed the market.

b) Diversified stock pickers, who were willing to measurably deviate from the indices against which they were measured, tended to beat the market.  He found that the portfolio managers who focused on stock picking and fundamental research (as a group) did better than the market.

Stock pickers can sell overpriced stocks before they collapse and then buy them back when they become cheaper.  Index funds cannot do this; in fact, they buy more of overvalued stocks and sell the undervalued ones.  Stock pickers can choose to include stocks in their portfolios based on fundamentals and valuation.  Index investors buy stocks as determined by the governing body of the S&P 500 (or other indices), based on factors which may not always be fundamental.  Stock pickers can determine whether or not a company is being smart in its use of its balance sheet and cash flow.  Stock pickers can measure the quality of a company’s management.  Passive investors can do none of these things.

This essay will likely not change anyone’s mind about the merits of passive versus active investing.  Yet, I would hope that my words might have raised some doubts to the notion that the “average” fund managers cannot beat the market.  The average ones may not, but the best ones (diversified stock pickers) can and do.

I am an active investor.  I’ve been doing it my entire career.  It works for me and for those who place their trust in me.