Few topics in fund are as hotly disputed since the feud between advocates of passive and active investing. Bloomberg Gadfly’s Nir Kaissar and Bloomberg View’s Barry Ritholtz recently met online to join the discussion. They discussed global equity valuations.
Barry Ritholtz: I have a foot in both camps, though my store runs a largely passive portfolio of cheap worldwide assets. So perhaps I’m not the perfect Boglehead to make the case for passive investing.
But, I think a big chunk of your portfolio — many — must be indexed. Let’s start our situation by pointing out four of the key reasons:
No. 1. Lower costs
No. 2. Better performance
No. 3. Avoiding closet indexers that mimic indexers but charge high prices
No. 4. Preventing harmful investor behavior
I hope to focus the majority of my energies on issue No. 4 — passive as a remedy for poor Investor behavior.
Nir Kaissar: I am not prepared to concede that lower price and better performance are on the side of passive investing.
First, let us define passive and active. To me, passive investing means buying a wide cross section of the sector and weighting the elements based on their market capitalizations. Everything else is busy.
The most ubiquitous manners of active management — such as value, momentum and quality — have historically conquered the wider market. The issue is that active managers kept the profits for themselves by charging investors absurdly significant fees.
Those busy fashions are now available in the kind of systematic, low-cost index funds which are equally as cheap — and sometimes cheaper — than passive funds. The Vanguard Value ETF, by way of instance, monitors a large-cap value index and fees only 0.06 percent annually. That’s less costly than many Conventional amp; Poor’s 500 mutual funds and barely more expensive than the least expensive Samp;P 500 exchange-traded funds. There are quite a few other examples.
So active is not necessarily more costly than passive. And because performance and cost are so closely related, I guess that active management will deliver much better results going forward than it has previously.
BR: We agree on variable investing and that some people today conquer the market; we also agree that overall low-cost, outperforming active management can and does exist — look at Bill Miller, Warren Buffett or your own track record as evidence of that.
But we must separate the overall average manager from the particular individual manager: on average, the majority of the lower prices and the majority of the industry performance are on the side of passive investing. The average active manager is expensive and typically underperforms their benchmark. The most recent studies suggest it’s even worse than we previously thought over longer amounts of time.
People aren’t that good at picking stocks that could beat their benchmark; nor are they particularly good at finding the stock-picker who will beat their benchmark. Some even select a professional to select the fund managers who will choose the stocks that beat the market.
How can anyone identify in advance who will outperform? And when an outperforming supervisor is situated, how do you know that he or she’ll continue to outperform? How can an investor inform when it’s luck or skill? What rules should you need for jettisoning a once-outperforming supervisor who no longer is outperforming?
I believe we both agree that pricey AND underperforming busy gives the whole complex a bad name.
NK I certainly agree that most actively managed funds are still too costly and so not likely to beat passive funds.
Investors have gotten the message. According to Morningstar, they pulled $578 billion in traditional actively managed funds and plowed $1.4 trillion to low-cost funds since 2015 through July.
But here is the secret: Of that $1.4 trillion, $1.2 billion went into passive funds and just $200 billion went to orderly active — or beta — funds. The obvious message is that investors do not have a lot of interest in active direction at any price tag.
So you are right to say that active managers have given active management a bad name. That should worry active supervisors and inspire them to rehabilitate their reputation.
They ought to begin by recognizing that there are intervals when busy styles do not work, and that the expected outperformance over the long term is small — probably 1 percent to 2 percent annually. They should then have a frank conversation with investors about the way that expected outperformance ought to be split between manager and investor.
Smart beta is doing these things, which explains why it’s seeing some inflows even as investors leave traditional active managers.
BR: Ahh, so there’s some rationality in Investorland! Let us proceed into the behavioral issues, which is my main beef with active.
This really is more about human foibles than it is about busy supervisors, although finance companies certainly know how to market to people’s worst instincts.
The record demonstrates that investors tend to pursue fund managers who have experienced a recent strong run, while jettisoning otherwise decent supervisors whose preferred style and/or asset category is close to the nadir of its cycle. It is among the most destructive investor behaviours around.
Consider how typical investors learn about any investment manager. It appears to occur after a wonderful run, perhaps with a few positive media coverage also. But of course, few managers can sustain such outperformance, and yesterday’s star money manager is tomorrow’s mediocrity. Is it any wonder investors typically underperform their own holdings?
Incidentally, “active managers have given active management a bad name” is a excellent sentence. I might need to steal that for a column name.
NK: It’s all yours! And I think it cuts to the heart of the debate since there’s nothing wrong with active management per se, although investors increasingly believe differently.
That is ironic because, as you point out, investors deserve some of the blame for the poor results they have gotten out of active management. I recently compared fund returns with investor yields for many different active and passive funds. I discovered that investors in passive U.S. stock funds captured on average 96 percent of the funds’ yields over the last ten years through July, whereas investors in active capital captured only 71 percent. I discovered the identical disparity among overseas stock funds. That’s further proof that investors tend to chase hot busy supervisors to their detriment.
But here, also, I believe smart beta might help. For starters, smart beta enables investors to create long-term bets on busy styles as opposed to active managers, the same way that a growing number of investors are betting on passive, capitalization-weighted indicators. Also, smart beta enables investors to compare busy managers with robots that are active, which should help them sidestep managers that are merely peddling high-cost active fashions without adding much value.
All that should give investors more certainty in their selection of active funds and bolster their ability to hang on.
BR: Today we’re at the main part of the debate! I’d rewrite your remark as: Investors deserve the majority of the blame for poor outcomes, because of not having a strategy they can or need to stay with, pursuing the hot hand, being psychological in their investments, and finally, their lack of discipline in following their own strategies.
Active management has waved shiny objects at investors and they came running. Some investors have figured out they should not behave like magpies — that is why there’s this stream into passive indexing because the amazing financial crisis. It is noteworthy that the huge majority of resources are still not handled passively.
My bottom line is most people are better off with cheap indexing for nearly all of their money. Yes, active does have a role in asset allocation and portfolio construction, but only when it’s 1) low cost; 2) additive to portfolio diversification; and 3) not used by shareholders to promote their worst instincts and behaviours.
NK: We ought to admit, however, the information asymmetry between investors and money managers. Many investors, including some institutional ones, need help placing those “shiny objects” in perspective.
But busy managers — and the broker markets who peddle their funds — haven’t been helpful. They generally wave around little more than the dazzling returns and five-star ratings of the best-performing funds. There’s very little warning that performance will be cyclical, or a fund’s active style happened to be in favor, or the way that penalties will likely impact the odds of future success.
So it is not surprising that investors have fared badly and an increasing number are giving up on active management. While it’s true that more money is still handled actively than passively, passive is fast gaining ground.
However, I do not think active management is moving away. It makes sense to diversify across energetic fashions, and the smart-beta bots have demonstrated that active management can be delivered cheaply and transparently.
The only question is if there is a future for busy managers in active management.
Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He’s the creator of Unison Advisors, an asset management company. He’s worked as a lawyer at Sullivan amp; Cromwell and a consultant at Ernst amp; Young.
Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a qualitative research company. He blogs at the Big Picture and is the author of “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.”