The investment management world of today can be divided into two broad categories of management style, each reflecting a fundamentally different belief system regarding how modern capital markets behave. These two schools of thought are generally referred to as active and passive management. This article will address these two approaches as they apply to stock market investments, but the observations apply with equal validity to the world of fixed income investments (bonds) as well.
Defining Active and Passive Management
Active management is the traditional way of building a stock portfolio, and includes a wide variety of strategies for identifying companies believed to offer above-average prospects. One method might focus on companies with impressive past growth in sales and profits, another on companies with promising new products, a third on "turnaround" potential of distressed firms, and so on. Another active management method known as technical analysis attempts to find "patterns" in price movements to predict the future prices. Regardless of their individual approach, all active managers share a common thread: they buy and sell securities selectively, based on some forecast of future events.
Passive or index managers - the terms are often used interchangeably - make no forecasts of the stock market or the economy, and no effort to distinguish "attractive" from "unattractive" securities. A passive manager investing in large domestic stocks, for example, makes no determination if Ford is preferable to General Motors, Coca-Cola to Pepsi, or Campbell Soup to Kellogg. Instead he or she simply buys every large company from Abbott Labs to Zion's Bank, resulting in a portfolio with hundreds of stocks. Once assembled, turnover is very low since every stock is intended to be held indefinitely. Portfolio adjustments are made only in response to fundamental changes in the underlying universe of stocks - when CBS disappears in a merger with Westinghouse, for example, or a new company such as Google joins the ranks of large company stocks. Passive managers often construct their portfolios to closely approximate the performance of well-recognized market benchmarks such as the Standard & Poor's 500 index (large U.S. companies), Russell 2000 index (small U.S. companies) or Morgan Stanley EAFE index (large international companies).
It Seems Too Simple
When first exposed to the concept of passive management, novice and experienced investors alike tend to dismiss the idea as hopelessly naive. How is it possible that a "mindless" strategy of buying and holding every stock can deliver higher returns than selecting only the most attractive stocks for purchase? Isn't it obvious that some companies have better prospects than others, and will thus be more profitable investments? Won't careful research by skilled analysts ensure superior results? Isn't the recent success of indexing just an aberration?
No, no, and no. As Victor Hugo observed nearly 150 years ago "One can resist the invasion of armies but not the invasion of ideas." Indexed investing is a force, not a fad. Despite the absence of any commercial interest group that would profit from its success, it has overcome enormous initial skepticism and has been embraced by most of the world's largest and most sophisticated investors. How did this idea get started and why does it work?
Passive Management in Perspective
The passive approach is a relative newcomer to the practice of investment management. Academic theories supporting the concept were developed in the 1950s and `60s. The nation's first stock index fund was developed in 1973 by Rex Sinquefield, a trust officer at American National Bank in Chicago. Sinquefield (recently retired) was the co-chairman of Dimensional Fund Advisors Inc., one of the worlds? leading innovators in passively managed investing. Active management, on the other hand, is as old as money management itself. Indeed, forecasting the future - Which stocks will do best? Which way is the market headed? - has long been considered the very definition of investment advice.
The theoretical work supporting passive management took place primarily at the nation's universities rather than the investment departments of major banks or brokerage firms. In the late 1960's, armed with increasingly powerful computers, academic researchers began to assemble a detailed history of stock and bond market returns, and to question assumptions never tested before.
One of these assumptions was the superiority of active management. At traditional investment firms, an army of economists, research analysts, portfolio managers and traders scrutinize an enormous daily flow of information on companies, industry groups, business conditions, and political developments. They produce stacks of detailed reports recommending stocks to buy or sell, and industry sectors to overweight or underweight. Does all this effort pay off? Are the nation's mutual funds, bank trust departments, corporate pension plans, college endowments, public retirement funds and insurance companies able to earn higher returns for their shareholders and beneficiaries following these recommendations versus a ?naive? strategy of simply holding a market portfolio of stocks?
The Proof: Mutual Fund Performance
Mutual fund returns are an excellent source of data on money manager performance since their results are audited by professional accountants and publicly available for all to see. Beginning with a landmark study by Michael Jensen in 1968, academic researchers have scrutinized the results of mutual funds covering a period of nearly fifty years. Not one major published study successfully claims that managers beat markets by more than one would expect by chance.
According to Morningstar, for the 15 years ending April 2006, only 40% (918 of 2,309) of diversified actively managed U.S. equity mutual funds managed to outperform the S&P 500 index.
Another important consideration in determining if money managers have beaten "the market" is how the US equity market is defined. Since the S&P 500 is predominantly weighted in large growth companies, if smaller or value companies have produced higher returns for the time period measured, the average money manager would have a built in performance advantage, since the average fund typically owns smaller companies or more value-oriented companies than the S&P 500 (a lower price/book ratio is more value-oriented).
S&P 500 Index
Average Company Size: $46 Billion
Price/Book Ratio: 2.8 Times
Actively Managed US Equity Funds
Price/Book Ratio: 2.8 Times
Average Company Size: $21 Billion
Using an index adjusted for smaller or more value-oriented companies, the percent of fund managers beating "the market" over the past 15 years drops to just 2.4%. This adjusted index beat the average actively managed U.S. equity fund by 4.69% annualized.
Another consideration necessary to truly understand the difficulty in beating the market has to do with "survivor bias". Mutual funds that closed or merged get deleted from commercial databases. Funds that no longer exist were generally poor performers. Studies have shown that 3% - 5% of mutual funds disappear every year. This has the effect of overstating the "average" fund for the period measured by an average 1% -1.5% annualized. Accounting for survivor bias reduces the percentage of market- beating funds to just over 1%.
An additional advantage of indexing is lower taxation due to lower stock turnover. Over the last fifteen years, Vanguard's S&P 500 Index Fund beat 95% of actively managed funds for tax efficiency. The extra savings from low turnover today could mean 1%-2% more return per year compared to the average actively managed fund. Presently, DFA Funds is the only provider of tax-managed passive funds.
Are Coin Flippers Lucky or Smart?
If 1% of the mutual fund managers were able to beat the market (before taxes), isn't that evidence that a small minority of active managers are genuinely skillful? Not necessarily. The number of active managers who outperformed the market is no greater than one would expect by chance. Suppose a football stadium were filled with 50,000 coin tossers, and after every flip only those tossing "heads" kept their seats. Since the odds of heads on a given toss are 50%, we should expect 25,000 people to remain after the first toss, 12,500 after the second, and so on. After ten flips probability predicts there will still be 49 people who have flipped heads ten consecutive times. Some of them might write books or appear on television shows touting their coin-flipping ability, but there is no reason to expect similar success in future contests. Likewise, we should expect a certain number of money managers to achieve superior results in any time period purely by chance. Choosing future winning coin flippers or money managers by studying track records is apt to produce disappointment and unsatisfactory results since it is impossible to distinguish between luck and skill.
Why Has Passive Management Been Successful?
The investment business attracts more than its share of bright, highly trained, and hard-working people. Why should outperforming an unmanaged index be so difficult? Some observers blame the mutual fund industry, citing increasing management fees and an explosion of new product offerings as evidence that fund companies are more concerned with gaining market share and increasing profits than improving investment results. Others criticize ?gunslinger? portfolio managers who allegedly take excessive risks with shareholders? money in an effort to edge ahead of competing funds. Investors themselves are faulted for not demanding better results from fund companies.
These criticisms are valid, but they miss the point. The implication is that beating an index would be easy if only managers weren't so greedy and tried a little harder. If this were the case, one would expect the performance of major pension funds, where investment mandates are clear, fees are slim, and competition keen, to show better relative results. Alas, the record of active management compared to indexing among these knowledgeable investors is equally unimpressive, which explains why institutional commitments to indexed investing strategies have mushroomed from zero to more than $5 trillion in the last 30 years. Many large pensions and 401k plans are utilizing, exclusively, index funds for their participants.
Adam Smith's Invisible Hand
What can explain the failure of active managers to perform better? Perhaps the best answer relies on the insights of Adam Smith, the 18th century Scottish economist whose A Wealth of Nations laid the intellectual foundation of free market economics.
Smith offered convincing evidence that the mechanism of signals based on freely determined prices was the best way for a social order to allocate resources. Countries that organized themselves around free market principles prospered, others did not. Most investors today consider themselves free market supporters, and around the world some of the most ardent advocates of free markets are those who have personally experienced the shortcomings of centrally planned economies.
Indexing a securities portfolio is the logical outgrowth of a belief in the effectiveness of a free market system. Just as prices for steel, oil or lumber quickly reflect new economic developments, so do prices for financial assets such as stocks and bonds. At any given moment, the price of a stock represents the best estimate of its worth by market participants, and is the collective decision of the ?right? price by all buyers, sellers, and owners of the stock. Do some companies have superior prospects due to a trusted brand name, breakthrough technology, unique marketing strategy, or financial strength? Of course, and this optimism is reflected in a higher stock price relative to other companies stock. Stock prices change, sometimes violently, in response to new information, but since news is by definition unpredictable, so are stock prices.
The Daunting Challenge of Beating the Market
To construct a market-beating portfolio, active managers must identify mispriced stocks. First, active managers must have information that is not only accurate, but not shared by other investors. Second, the manager must be willing to share this information with their clients. Third, in order to profit from this insight, other investors must act upon this information at some future date, causing the mispriced stock to change and reflect its ?real? value. Fourth, in order to add net value, the ?excess return? must exceed the cost of information gathering, trading and potentially higher taxation. Fifth, the manager must repeat this process over and over again. In a world where information is rapidly disseminated, and use of ?inside? information illegal, this is a tall order. In such a world, gaining a sustainable advantage over other skilled participants in a hotly competitive marketplace is extremely difficult. The fact that there aren't consistent winners among money managers clearly demonstrates how competitive market forces effectively determine security prices.
To be successful, active managers must consistently find mispriced securities. Thus, the failure of active money managers to perform better is hardly a negative; it is solid evidence that capital markets are functioning efficiently.
The Leap of Faith
Suppose that a mutual fund or money manager satisfied rigorous analysis and demonstrated added value, additional challenges persist to expect continued superior returns.
Common Objections to the Passive Approach:
- Market conditions that enabled the manager to beat the market may no longer exist.
- The strategies that were used to extract inefficiencies from the market to earn superior returns may be duplicated by other skillful managers eliminating the competitive edge.
- The strategies employed may no longer be effective if the managers? assets get too big. Trading volume and liquidity will eventually become a constraint.
- The manager may raise their fees (as justified by the superior record) potentially eliminating the anomalous extra return.
A large number of highly-paid analysts, portfolio managers, and investment executives and popular financial press have a vested interest in maintaining the traditional industry bias toward active management. The most frequent objections from advocates of active money management are as follows:
"Indexing works well for actively traded U.S. Large stocks because these firms are closely followed by dozens of analysts and discovering useful information not already known to other investors is therefore very difficult. It doesn't work as well for less-researched areas of the market such as small company stocks, foreign securities, and especially emerging country stock markets."
Indexing works well in all asset classes. A key advantage of the passive approach is low management fees, low turnover costs and greater tax efficiencies. In every market, all stocks must be owned by some investor. There is no such thing as a stock not already owned by someone. Active investors, as a group, must by definition underperform a strategy that passively holds a market portfolio of stocks, since active investors incur greater transaction costs. The reduced liquidity of small companies or emerging country stocks incurs higher transaction costs, making it even more difficult to outperform a passive strategy.
For example, for the 15 years ending April 2006, a blend of small cap indices/funds beat every actively managed small cap fund by an average 6.30% annualized. For ten years ending April 2006, a blend of emerging markets indices/funds beat every actively managed emerging markets fund by an average of 5.63% annualized. (We?ve selected the last ten years for emerging markets funds because there were so few emerging markets funds over the full 15-year period.)
The best that can be said for the active management approach is that the dispersion of results between the best performing and worst performing active managers is likely to be greater in less liquid markets. In other words, some active managers will do much better than the market, but others will do much worse: it's a zero-sum game. Since there is no reliable way of identifying superior active managers in advance, active management simply adds uncertainty to the investment process.
"Index funds may outperform the average fund but I don't pick just average managers. If indexing is so superior, how does one explain the results of active managers who have outperformed the market for 10, 15, or even 20 years? It can't be just luck."
Statistical probability shows us that in a given time period we should expect some number of active managers to beat the market, even by substantial margins.
Historical data supports the idea that past performance can't be used to select managers who will continue to beat the market in the future. Numerous studies of "superior" active managers or mutual funds consistently show the tendency to "regress" or become average, even after long periods of stellar results. For example, from its inception in June 1963, the Fidelity Magellan fund has been the best performing U.S. equity fund, but has lagged behind the S&P 500 over the last 15 years ending April 2006. Fidelity's Magellan Fund collects $190 million more annually in fees than Vanguard's S&P 500 Index Fund. If "paying for research" to beat the market really worked, wouldn't $190 million be enough?
Moreover, much of the allegedly superior performance of managers who have outperformed the market as measured by the S&P 500 can be explained by asset class exposure, not superior stock picking. When compared to a more appropriate passive index that incorporates high-return market dimensions such as small company stocks or value stocks, their seemingly superior performance disappears.
"Index funds are fine when stock prices are rising, but are powerless to deal with a severe market downturn. Who wants to own a stock fund that stays 100% invested in equities when it's obvious the market is collapsing?"
This objection assumes investors can successfully time the market, knowing the best time to get in or out of stocks. It's never obvious when the markets are going to go up or down - in advance. Mutual fund data clearly shows that, on average, actively managed funds have added no value in down markets. Any investment portfolio should be constructed with the understanding that sharp stock market corrections are not just a possibility but a certainty. It is impossible to predict, however, when these corrections will take place and when a subsequent recovery begins. An effective asset allocation among dissimilar asset classes and periodic portfolio rebalancing, not market timing, is a better solution to investor concerns of a market downturn. Further, if an investor's ?comfort level? (acceptable risk) dictates only a 60% exposure to stocks when stock prices decline, this should be the maximum exposure when prices rise as well.
"Indexing is just an academic theory. It needs more time to be proven."
Just the opposite is true. The evidence in favor of the passive approach is so overwhelming, both from a theoretical and empirical standpoint, that the burden of proof rests with traditional active managers to justify their contribution in view of their higher costs and greater uncertainties.
Casino Versus the Gambler
Casino owners understand mathematics is on their side. The profit margin for casinos is typically a 2%-5% advantage over the player, sufficient to support a multi-billion-dollar industry.
If given a choice, most "players" would rather be the casino instead of the gambler, due to the built in advantage the casino has.
The same idea applies to the world of capital markets. An index or passive investor has a similar mathematical advantage as the casino. Indexing typically provides investors an advantage in performance of 2%-5% per year, after taxes. The 2%-5% advantage provides an enormous amount of additional wealth over time. The index advantage occurs due to lower risk, lower costs, and less taxation associated with passive investing.
In the span of 30 years, passive management has progressed from an oddball academic theory to the cornerstone of institutional investment portfolios, representing roughly 40% of equity assets. If individual investors continue their historic pattern of gradually emulating the strategies pursued by institutional investors, index funds are poised for substantial growth, since less than 5% of individual investor assets currently utilize this approach. Employing a portfolio of passively managed index funds can enable any investor to achieve their financial goals with greater certainty and less risk.
1) 45% U.S. Large Value, 30% U.S. Small Value, 15% U.S. Megacap, 10% U.S. Microcap