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Retail Investor .org |
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ACTIVE vs. PASSIVE INVESTING RETURNSDoes Passive Outperform?It is common to hear the claim that passive indexing outperforms active management, except for short run flukes. If the claim is correct, then all the time, effort, training and worrying that go into active stock selection is all a fool's errand. This page by J.Norstad is a very good summary of all the arguments PRO passive investing. But there are a lot of problems with doing a proper analysis of this issue, and academics have provided little guidance. Following are the arguments AGAINST the claim. All Norstad's points are addressed. Notice that proving the assertion wrong does NOT prove that active investors outperform passive. It means only that it is POSSIBLE for active investors to outperform. ............................... ONE: Consider that the return claimed by the indexers is an index's theoretical total return (as made actionable with an ETF). But investors' realized returns are very different.
Returns from active management have no theoretical counterpart. They are always measured as 'actual realized returns'. So for any fair comparison between strategies the theoretical index returns cannot be used. The actual return of investors labeling themselves 'passive' has to be used. ............................... TWO: After all their other arguments have been discredited, the indexers always change the subject to "Indexing (passive) is the most appropriate strategy for retail investors". Since most retail investors do not have the time, interest or training to pick stocks, OF COURSE passive indexing is most appropriate. But that is not the issue being discussed. The issue is performance returns, not which strategy is appropriate for whom. Another straw-man arguments that no-one disagrees with are "All portfolio returns that beat the market are offset by other portfolios with lower returns ... because the market is the sum of its parts". This is the argument presented by William Sharpe in this article. But the issue asks whether SOME people do well with active investing, whether you CAN do well. Not everyone need outperform for it to be a valid strategy. Another straw-man argument is "Managers who outperform in certain types of markets, underperform the other types". Again no one disagrees because it makes no point. The active investor is free to retreat to passive investing in markets he knows his personality does not suite. It is very common for active investors to index during bull markets but change to stock-picking in recessions. It is the indexer who is constrained by ideology not the active manager. ............................... THREE: Consider the chosen method of calculating rates of return. There are different methods for different points of view. You must use the correct method for each issue. Take a simple example.
But what happens if you add $750 of additional savings to the portfolio at the half-way point? You are not changing any of the investing decisions or their outcomes. The only thing that changes is you double-up the money invested.
If the performance of an individual is being measured it is accepted that the second half losses are more heavily weighted in the calculation by the larger invested dollars during that period (using IRR calculation). This spreadsheet would calculate a 5.7 % LOSS. If the performance of a mutual fund manager is being measured it would not be fair to adjust for the added savings because he has no control over those. That decision is made by the unit holders, not him. If you are measuring only his 'active management returns' you would ignore those weightings because his investing decisions were not changed. In fact mutual funds report returns that ignore weightings. They measure the return of an individual unit over the whole year. In this example assume the mutual fund started with 50 units outstanding, each valued at $10. The additional savings at midyear doubled the number of units (an additional 50 units, each valued at $15). The year ended with 100 units, each valued at $12. Resulting in a published 20% return (12/10 -1). But maybe the academic is trying to measure the groups' returns, distinguishing between an active group and passive group. The additional weighting during the second half reflects actual investors' money. It cannot be ignored in calculating the total for the group. Similarly for measuring the return earned by an index ETF. Measuring only the 'per unit' return ignores the reality that in different months the fund may have many more/less units outstanding. When measuring the return of the indexing 'group' you should weight their returns by the units outstanding during that portion of the year. ............................... FOUR: Most often the only real argument to support the superior returns of passive indexing comes from a comparison of returns between high-fee active mutual funds and low-cost index funds (or ETFs). This argument's use of mutual funds is invalid on many levels.
............................... FIVE: Other research supporting the conclusion that passive investing outperforms, comes from analysis of pension plan returns. Although slightly different, pension plans have most of the same problems as mutual funds. They are only a subset of the actively managed world. Their funds are allocated to money managers just like individual chose mutual funds - with the same propensity to chase past performance. The managers charge fees just like mutual funds charge fees. Those managers' results are benchmarked just like mutual funds with the resulting pressure to conform to an index. Maybe most importantly their results are similarly public and subject to scrutiny and critique. To play the markets well you must believe in yourself. You need mental toughness to take positions shunned by everyone else and hold through turbulence. The publicity attached to a year of poor performance can wreck havoc on your self-confidence. It is no wonder that future performance suffers when everyone is watching and waiting for you to fail. The retail investor at home need tell no one. We can find all kinds of excuses to make ourselves feel better. In other ways pension plans differ from mutual funds. Unlike mutual funds whose reported performance measures that of the manager, pension plans' returns are measured and reported from the POV of the plan itself - making the results look worse (like the 5.7% loss above). Then again, managers of pension plan assets do not have to deal with the cash flow problems of mutual funds. The steady cash flow of premiums and benefits are predictable and largely offset each other. Overall, the drag on returns from these particular structural arrangements make the returns from pension plans not really representative of returns for the active management strategy - just like mutual funds. ............................... SIX: The academic research seems to avoid addressing this issue head on. There are always very good reasons to disregard their conclusions due to methodology. One really objectionable practice is to pretend to be measuring individual's stock-picking results, even while ignoring their actual transaction prices. Instead the researchers substitute the security's month-end value. So they have explicitly presumed there is NO value to stock picking in their research to determine IF there is any value to stock picking. There is a recurring theme that gets an honourable mention in many, many papers (just one example). The authors comment that individuals with higher returns in one period seem to continue outperforming in other periods. In other words, some people have 'IT' and other people don't. Since the period being studied is almost always short, with only one 'type' of market, it should not be concluded that 'IT' investors will still have 'it' when a market swings from (e.g.) bull to bear. But the comments do indicate you may be selling yourself short by simply concluding you don't have 'it' - by indexing - by not even trying. There is really NO research that even starts to measure the returns of individual investors over time. The necessity to distinguish between active and passive, to distinguish between day-trader 20-year-olds and retired investors in blue-chips, to factor in leverage costs or offsetting portfolios at different brokerages, etc. makes this an impossible task. Their cash movements in and out of accounts over time makes the measurement of returns in different types of markets impossible. But these measurements are necessary for any conclusions about the claim that passive investing outperforms. Active investors are retail as well as institutional. You must measure both for any conclusions. There is a separate page devoted to the existing academic research. You will find links to the articles and discussion about their results and shortcomings. ............................... SEVEN: Some indexers never claim passive investing gives superior returns. They claim only that active investors do better than the benchmark some of the time, and worse some of the time, while passive investing gets rid of that risk by equaling the benchmark every time. They admit some managers beat the index and others underperform, while indexers always equal the benchmark. This is just weaseling out of an argument. There is nothing wrong or inferior about portfolio returns in individual years that differ from the index. As long as your long-term results meet or beat the benchmark, who cares if they are different? If half (or even less) the active managers beat the benchmark that should be incentive to see if YOU are one of those people. If you can beat the index only in certain markets (e.g. corrections) you are free to index the rest of the time. ............................... EIGHT: Some indexers claim superiority by simply dismissing the reported returns of active investors. They claim these investors do not know how to properly measure returns - either on a year's basis, or multi-year basis. But no proof is presented for this position other than personal anecdotes. Discussion forums for indexers provide plenty of evidence that indexers themselves do not measure their returns properly (or at all). Other stock-pickers' results are rejected by claiming the wrong benchmark was used for comparison. They argue that since the portfolio included (e.g.) foreign stocks or value stock, or small-cap stocks, then the comparison benchmark should also be weighted for these sectors. E.g when Warren Buffett ouperforms the S&P Index, they claim "He did not outperform the Value Index and that is what he owns". This argument is wrong because it uses hindsight to determine the benchmark. Buffett is free to own public or private equity, debt, derivatives, commodities, etc. He was never constrained to value stocks. He chose what he owns freely. If he chose value stocks, and value stocks outperform, he deserves the kudos. Other results are rejected because it is decided the stockpicker's holding were more risky than the benchmark. But even accepting that as fact, was the benchmark chosen wrong? The correct choice of comparison benchmark should be the index tracked by the ETF the investor WOULD HAVE OWNED if he had not stock-picked. The investor does not say to himself "I can handle more volatility than the index so I will decrease my asset allocation to debt when I buy an ETF, and increase the allocation when I stock-pick." He does not say to himself "I can handle more volatility than the index so when I buy an ETF I will leverage it with borrowed money." In real life that never happens. The asset allocation decision is made before the decision whether to stock-pick or index. The stocks chosen are the ones with potential profits, regardless of their supposed class-risk. Other stock-pickers' results are rejected because their returns were greatly impacted by only one or two great years. So what? Who thinks we are invested in risky assets for a short time frame? What matters is the return over the whole period between when the $$ were saved and when they were eventually spent. Whether the stock-picker outperforms by protecting assets during short-lived recessions or by outperforming during extended up-markets is irrelevant. ............................... NINE: Indexers dismiss individuals' long-run record of outperformance with the argument that "It doesn't count because it was only to be expected from the random variable outcomes of cumulative 50/50 yearly probabilities of beating the index (i.e. luck not talent)". The intuitive error in that logic is shown by simply replacing "the probability of investors outperforming the index" with "the probability of your teenager's marks being in the top half of the class". The application of the argument is exactly the same.
No parent would buy that argument. Did the logic of the statistics argument justify the kid's conclusion? No. We know for a fact that the statistics argument is wrong because the issue is 'provable'. We can measure time studied and the resulting marks. When the issue is NOT 'provable' (like the investing issue) then we get seduced by math's authority. But the argument was invalid in one situation and equally invalid in the other. The argument is invalid because it PRESUMES the exact same situation it is trying to prove. Binomial statistics presumes 50/50 random chances in its model. You cannot prove "that investment returns are due to chance" (not talent) with an argument that takes as its starting point "that investment returns are do to chance". The only conclusion that can be drawn from the argument is: "IF investment returns were due to chance THEN you would expect some people to outperform over long periods". But the question "ARE investment returns due to chance?" has not even been discussed, much less proved. ............................... TEN: Some indexers argue: "Show me a system that will consistently outperform the index ... then we'll see." There is no logic to this argument. This person wants a 'system' with rules that can be followed without subjective evaluation, judgement or thought. OF COURSE this person should be indexing. No one says otherwise. It is common sense that any repetitive and exploitable pattern that can be discovered will be arbitraged away immediately. Stock-picking is not a paint-by-numbers application of rules, it requires skill. It is highly subjective, requiring trade-offs of many different good and bad attributes of each company. The fact that stock-picking cannot be reduced to a set of rules does not prove anything regarding the issue of whether an individual with skill can beat the index. Burton Malkiel's "A Random Walk Down Wall Street" suffers from this same logical disconnect between the description of reality that few would dispute, and his conclusions. It is like using the argument "University campuses are beautiful therefore you should get a university education." At each chapter's end his conclusion causes you to ask "Where did THAT come from?" In many cases you ask "Didn't he just prove the opposite?" ............................... ELEVEN: There has to be a mechanism for the markets to remain 'true' to correct (in hindsight) valuations. Indexing applies capital to stocks in their pre-existing market weightings. It does not change their relative values. Without active managers the markets would become 'wrongly' priced almost immediately. So there is a theoretical gain for investors willing to 'correct' the market. Even while not every active investor will make the right call on 'true' value, in total the correct (in hindsight) active investors must predominate in order to move any stock's price. They will benefit from alpha gains. They reap the benefit from closing the gap between yesterday's valuation and today's new reality. It is interesting that indexers also use the Efficient Markets Hypothesis to justify passive investing. Their argument is that market prices are always correct and quickly reflect new information - so it is impossible to benefit from mis-pricing. The error in their logic lies in their presumption that the price correction happens by magic, without anyone gaining from it. SOMEBODY must move the price. That person will gain alpha. The indexers respond with: "But those gains will go to the big boys with millions to spend on analysis and huge trading floors, etc. The retail investor does not have a chance of outgunning them." But that argument contradicts their basic position that returns are a matter of chance only (unless there is access to private information). ............................... TWELVE: The secondary stock market where retail investors play is a closed system. For most purposes the movement of cash between the primary and secondary markets can be ignored (IPOs and going-private transactions). In aggregate, if some player wins, another player loses. A theoretical argument can be made for the superior returns of stock pickers by balancing the known returns of the other strategies.
............................... CONCLUSION: The issue is very difficult to analyse. The most common argument using only mutual funds or pension funds has no merit. The academics have not devised appropriate studies. Nor is it likely they can. Most people believe what they want to believe. What you want to believe derives from your opinion of the Efficient Markets Hypothesis. Specifically, do you consider available information to be CORRECTLY priced into the market, or do you consider all information to be incorporated - but not necessarily correctly.
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