The debate over the relative merits of passive and active investing rages on. Proponents of passive investing rightly point out that most active investors lag their benchmarks and that index funds provide easy access to financial markets for a lower fee. Besieged defenders of active investing argue that disciplined research is a necessary component of long-term investment success, but the drag of active fees weighs heavy in an environment of modest returns. Investors are voting with their wallets, withdrawing $259bn out of active equity funds over the past year, while investing $185bn in passive approaches.
Neither of these opposing camps is likely to yield, but thoughtful investors can benefit from the debate by considering how and why passive strategies outperform most active funds. Rather than rehearse the details of the argument, I will explore why passive investing has succeeded and consider the insights that active investors can derive from that success.
Lethargy bordering on sloth
Much of the benefit of passive investing can be attributed to low turnover. Active managers take positions that differ from the index, and buy and sell as opinions change. Passive managers only buy and sell as the composition of the index changes – and that doesn’t happen very often. The turnover of active managers is therefore almost always higher than passive managers. Herein lies an important contributor to the relative success of passive investing.
Buying and selling stocks costs money and therefore acts as a drag on performance. In addition to per-trade commission charges, investors ‘pay’ the invisible cost of the spread between the asking and offering price of a security. A recent Morningstar study concluded that trading costs reduce the performance of the average active equity fund by between 10 and 20 basis points per year. That’s not a huge burden, but those small costs compound over time and rise with the frequency of trading.
Investors pay commissions on the day of a trade but often pay again much later – and much higher – when they receive the tax bill for capital gains incurred through trading. Lower turnover reduces trading costs, but the far more valuable benefit is that it allows more of your money to keep working for you by not trading, realising gains and paying taxes on those realised gains.
The benefit of passive investing is that it more or less does the job for us by reducing the opportunity for error
A final and far more subjective benefit of low portfolio turnover is psychological. Behavioural psychologists have compiled a long list of repeatable and predictable ways in which human beings act contrary to their own interests. Among other tendencies, we have too much confidence in our own opinions, naturally seek confirmation of our beliefs while ignoring contrary evidence, place too much importance on available information, see patterns where none exist and generally believe that we have far more control over our future than we actually do.
This isn’t to say that we are stupid, but that we are normal. Seneca the Younger had it right when he observed errare humanum est – to err is human. Put differently, the fewer decisions you make, the fewer mistakes you make. A low-turnover approach simply reduces the opportunity for error.
Rigorous discipline is a vaccine against behavioural bias. It enables us to avoid being misled by the instinctive, emotional and reactive part of our nature and to replace it with patient, analytical and deliberative thought. This is not easy, and the benefit of passive investing is that it more or less does the job for us by reducing the opportunity for error.
A passive investment approach based on a stable underlying index provides an investor with the benefits of lower trading costs, more efficient tax treatment, better opportunities to compound returns and less risk of emotional interference. These advantages are also available to active investors who avoid the temptation of frequent trading in favour of a more patient and disciplined approach. To quote from a letter to the shareholders of Berkshire Hathaway, Warren Buffett memorably and poetically affirmed in 1990: “Lethargy bordering on sloth remains the cornerstone of our investment style.”
Daring to be different
The inability of most active managers to consistently beat an index reflects yet another behavioural bias: regret avoidance. In an attempt to avoid significant, and perhaps career-ending, underperformance, many active managers are reluctant to stray too far from the index against which they are being measured. Conventional success in money management leads to job security and raises. Even failure, if conventional enough, leads to job retention.
An old Wall Street adage holds that it is far better for a professional investor to succeed unconventionally than conventionally. Unconventional success leads to fame and glory. Yet unconventional success requires one to assume the risk of unconventional failure, and unconventional failure leads to getting fired. Most managers prefer to fail conventionally and keep their jobs rather than assume the risks required to succeed unconventionally. The poor track records of most actively managed funds reflect this desire to avoid the regret of being unconventionally wrong. Job preservation trumps wealth preservation.
The degree of a portfolio’s unconventionality can be measured through a concept called active share, calculated as the sum of the absolute differences between the weights of each stock in an index versus a portfolio, divided by two. An index fund that perfectly replicates the index has an active share of zero percent, whereas a portfolio that owns no names in common with its relevant index would have an active share of 100 percent. Mimicking an index, as reflected by a low active share, magnifies the performance drag associated with turnover, making it difficult for managers to beat an index even before a higher level of fees is taken into account.
Conventional wisdom holds that portfolios with higher active shares are riskier, yet this conclusion implies that risk is defined by deviation from a benchmark. This definition of risk lies at the foundation of modern portfolio theory, stretching all the way back to Harry Markowitz’s seminal paper on portfolio selection published in 1952. Is it any wonder that many portfolio managers address both portfolio and career risk by sticking close to the index against which they are measured?
True active managers define risk as a permanent loss of capital and manage it by willingly deviating from the benchmark. In many cases, this results in a concentrated portfolio of companies and high active share, which increases the potential for superior returns. It is important to note that high active share does not guarantee superior returns; it simply magnifies the impact of investment insight, either for better or worse. Concentrated portfolios furthermore offer additional protection against the behavioural biases outlined earlier. The temptation to sell a company into weakness diminishes when you know its underlying value so well that price volatility doesn’t shake your conviction.
Superior active managers embrace the benefits of low turnover. They appreciate the power of compounding and have the discipline to hold stocks that are performing poorly – or even take advantage of price volatility by adding to those positions. They tend to have a substantial portion of their own wealth invested alongside their clients. They are not interested in launching new mutual funds and attracting billions of dollars of assets because the performance of their portfolio over the long run is a more important driver of their own wealth. Finally, they tend to be privately owned firms that care more about the sustainability and growth of their business than job security. The peculiar incentive to fail conventionally and keep your job doesn’t apply when you are your own boss.
These managers don’t aggressively market their track records, and those records are, therefore, largely absent from the databases that analysts rely on to argue for the superiority of passive over active investing. If those databases were expanded to include less conventional managers who assume a higher active share, we wonder if the returns of passive investing would look as competitive.
Having your cake and eating it too
Investors can have everything they want as well. Many benefits of passive investing, such as low turnover, tax efficiency, compounding returns and resistance to behavioural biases, can be obtained through active approaches. Concentration and high active shares are ingredients for investment success, although it takes the right combination of discipline, skin in the game and independence to encourage a manager to stray from the herd in pursuit of superior returns. Investors should always gauge the skill of an investment manager based on after-fee returns, and we conclude that managers who share these characteristics of success warrant the fees they charge, while admitting that there simply aren’t that many of them out there.
While this article won’t settle the debate between active and passive investing, proponents on both sides cling to their arguments as if they were articles of faith. Active investors should acknowledge the challenges associated with providing superior returns, and borrow from the success of passive approaches in pursuing those returns.
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