Synthesising the Active vs Passive Debate – Bonus Material

Link to: i3 Insights: MarketFox – Synthesising the Active vs Passive Debate

Next week is marks the launch of my new column for i3 Insights, the Investment Innovation Institute’s (or i3) monthly online magazine. Institutional investors in Australia and Asia would be very familiar with the excellent work that Teik, Wouter and the team do in bringing thought leaders from around the world to exchange ideas. I’m honoured to be asked to present my ideas among such distinguished company.

We thought it might be interesting to get things started with a new take on a very old topic: the active vs passive debate.

I know what you’re thinking: is there anything left to write about? Turns out that there’s plenty to write about if you synthesise the two sides of the debate together. Synthesis is what’s largely been missing from the active vs. passive debate.

Synthesis is important because the answer to the active vs passive debate is this: it all depends on the circumstances (see my earlier post).

There’s a lot to cover so I’ve divided it up into three parts:

  1. Commonly offered reasons why active management so often underperforms, some of which are poor because they don’t really explain the poor performance of active fund managers.
  2.  More plausible reasons why active management usually delivers poor results.
  3. Strongest arguments in favour of indexing.

For part I, I came up with 13 arguments (see below) that are usually offered as “proof” that active management is a bad idea.  Most of these arguments are either weak or apply in some circumstances but not others. And yet they are the arguments that often get the most attention.

My i3 Insights features nine arguments, the remaining four arguments appear below. They are:

  1. Even if some managers do win, you can’t pick the winners in advance.
  2. There are now too many smart people investing in the market making it harder to beat.
  3. Some people do beat the market, but that’s because they take more risk.
  4. Warren Buffett says that Jack Bogle is his hero. I’d better do what Buffett says.

Even if some managers do win, you can’t pick the winners in advance

That’s true of most things in life. I think this is the logical equivalent of saying: “you don’t know where the fish are, so why go fishing? While its true that nobody knows where the fish are, we do know which species are commonly found in the area, their habits (e.g. deep sea) and what they like to eat.

Even though you aren’t guaranteed to catch a fish every time, it happens often enough to be a worthwhile activity. And who can deny that some people are genuinely skilled at fishing, even if they don’t always catch a fish?

In a similar way, we know many of the factors come together to create a successful investment strategy. Much more importantly, we know the factors that ruin our chances of success, such as:

  • High fees
  • High turnover
  • Benchmark hugging
  • Managing too much money

Trying to find the “best” fund manager is usually a waste of time. It’s just like trying to pick a winner in a horse race, the best horse winds up being the favourite, is heavily backed by most punters and consequently even if you’re right you end up making very little money.

Instead, look for weaker markets, and behavioural edges, invert, exclude the losers then pick the cheapest of what’s left. A better way to invest actively is to prioritise areas of the market where active management is more likely to work, for example a microcap strategy. Identify the behaviours that promote successful investing. Behaviours are far more persistent that performance, so it makes sense to base your search strategy on them.

The next step is to flip or invert the behaviours around and work out all of the wrong behaviours that investors need to avoid. I then screen the universe of fund managers for these bad behaviours and remove any managers that repeatedly engage in them. The final step is to then select the cheapest manager out of the remaining group of shortlisted managers.

The goal of this process is to maximise the expected value of active management for the investor, not the fund manager (see my earlier post).

Most people I share this approach with think I’m crazy. I can see from the expression on their face that they’re thinking it’s just wrong to not try and pick the best, or that I’m just settling for the cheapest fund manager (not true!).

The truth is that it’s hard for most people to accept that it might be easier to avoid a bad fund manager than it is to find a good one; especially when they are being paid a lot of money to find a good one. Then there are behavioural biases such as over-confidence that come into play.

This quote from Warren Buffett’s 2016 Berkshire Hathaway annual letter sums the problem up nicely.

That professional, however, faces a problem. Can you imagine an investment consultant telling clients, year after year, to keep adding to an index fund replicating the S&P 500? That would be career suicide. Large fees flow to these hyper-helpers, however, if they recommend small managerial shifts every year or so. That advice is often delivered in esoteric gibberish that explains why fashionable investment “styles” or current economic trends make the shift appropriate.

Michael Mauboussin has observed that the simplest definition of whether or not the outcome of an activity is due to luck or skill is this: can you lose on purpose? If you can’t deliberately lose, then the outcome is dominated by luck.  So, if we can’t identify bad managers, we’re really just getting paid for random outcomes. Something to pause and reflect on.

There are now too many smart people investing in the market making it harder to beat

Yes, the market is really tough to beat and most people are probably better off not trying. But I think it’s debatable that this is due to the problem of too many smart people operating in the market for 3 reasons which I explained in detail an earlier post, they are:

  1. Markets may attract the wrong kind of people as investors
  2. Even the smartest people are still people
  3. Smart people may be looking out for their own interests

Some people do beat the market, but that’s because they take more risk

Academic studies show no clear relationship between market risk (beta) and return.

Several factors have been demonstrated to out-perform the market and most active managers either knowingly or unknowingly target these factors as part of their investment process. I cover this in my i3 Insights post.

Warren Buffett says that Jack Bogle is his hero. I’d better do what Buffett says

Don’t mistake Buffett’s comments about the business of investing for his views on the activity of investing. Buffett’s recommendation to invest passively isn’t because it’s impossible to beat the market (although he acknowledges that it’s become harder). Rather, he believes that the activity of investing can still be rewarding for those with the right temperament.

That said, the business of investing is riddled with principal and agent conflicts and high fees making active management unlikely to be a winning proposition for the client. Paying someone else to do it for you is more often than not going to result in the fund manager becoming wealthy (not you). For example, see my earlier post.

Here’s Buffett on the subject. This quote from Berkshire Hathaway’s 2016 annual letter.

Finally, there are three connected realities that cause investing success to breed failure. First, a good record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions (sob!). Third, most managers will nevertheless seek new money because of their personal equation – namely, the more funds they have under management, the more their fees…

… The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.

Most people don’t have the right personality and/or circumstances. Buffett doesn’t advise people to invest passively because the market is efficient, or any of the other reasons we’ve considered.  He simply recognises that most people don’t have the time, knowledge or temperament to invest actively.

Temperament is the most important of these factors, as Buffett explains in the CNBC interview.

Buffett CNBC

Part 2 of my series on active vs passive management will appear on i3 Insights in May.

In the meantime, readers might enjoy previous posts dealing with the active vs passive debate.

Link to: i3 Insights: MarketFox – Synthesising the Active vs Passive Debate

 

13 weak arguments against active management

  1. Markets are efficient. Prices reflect all public information (semi-strong efficiency).
  2. Diversification is the only free lunch. The market-cap index is well-diversified.
  3. Between 60-90% of active fund managers under-perform each year
  4. There is little or no performance persistence from year to year.
  5. There are now too many smart people in the market making it harder to beat.
  6. Active management is simply factor investing at a higher cost.
  7. Regulation and technology have reduced many of the information asymmetries that made active management profitable.
  8. Some people do beat the market, but that’s because they take more risk.
  9. Get enough coin flipping orangutans tossing coins and at least one will come up with 10 heads in a row (luck).
  10. Positive Skew. The majority of the market’s return is due to a handful of stocks. You want to diversify and buy-and hold so that you capture these engines of growth.
  11. Warren Buffett is just a freak. We shouldn’t try to copy him.
  12. Warren Buffett says that Jack Bogle is his hero. Better do what Buffett says.
  13. Even if some managers do win, you can’t pick the winners in advance.
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2 comments

  1. Victoria Rati · April 17

    Hi Daniel

    I trust you had a nice relaxing Easter break
    with family and friends.

    congratulations on your on your new I3 column

    With warm regards Victoria

    Sent from my iPhone

    PS note this email address is only monitored periodically . For anything urgent do you call on the mobile

    Like

  2. Pingback: The Active vs Passive Debate – Part 3 | marketfox

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