Active vs. Passive Investing

At the heart of the debate of Active vs. Passive Investing, there exists the fundamental question as to whether there are market inefficiencies that are consistently identifiable and exploitable for profit.

Active investors believe that they can apply certain strategies, namely in the form of stock picking, market timing, manager picking and style drift to capture such market inefficiencies and garner wealth. In contrast, passive investors contend that all information that can be known is widely dispersed among all market participants, making it virtually impossible for any one person to consistently possess information they can exploit for profit.

The debate between active vs. passive investing has dragged on for more than 40 years; certainly far longer than necessary as reams of academic research continue to reveal the failure of active management to outperform a passively managed and properly selected market index benchmark. The debate rages on however, for three reasons: First, active managers have a compelling reason to keep the grand illusion of market-beating prowess alive: they charge more money than their passive manager counterparts. They justify this extra expense as the price that must be borne by investors who believe they can achieve “market-beating” returns.

In his eloquent opening statement prepared for just such an active vs. passive debate in October 1995, Rex Sinquefield, co-founder of DFA and now a director with the fund company, elaborated on the temptation of active investing. “It’s easy to understand the allure, the seductive power of active management. After all, it’s exciting, fun to dip and dart, pick stocks and time markets; to get paid high fees for this, and to do it all with someone else’s money,” Sinquefield stated.

The financial motivation is clear for the advisor who actively invests on behalf of his clients, but what is the allure for his clients? This brings us to the second reason as to why the active vs. passive debate lingers on: Hope springs eternal.

While there exists little sound basis to justify active investing—surely the properly benchmarked returns readily reveal the failure of such a strategy—active managers prey on the emotions of investors. They would have them believe that certain signals, known only to them, can avoid large losses or capture big gains. At the center of this hope is the steadfast presumption that there are fundamental discrepancies in free markets that can be exploited for profit. While this notion dangles the carrot of easy money, no such promise can be fulfilled in efficient markets. But, you shouldn’t just take our--or anyone else’s--word for it.

Due diligence is the cornerstone of prudent investing. To that end, the 15 pie charts below provide an excellent summary of the results of active vs. passive investing comparisons.

The many studies illustrate that across virtually all asset classes, the corresponding market index outperforms the vast majority of its actively managed counterparts. In fact, the average percentage of occurrences in which active beats passive is just 8%. Whether you look at market-timing stock and fund pickers or actively managed funds benchmarked to the S&P 500 Index, IFA’s Large-Cap Value Index, IFA’s Small Cap Value Index, IFA’s International Value Index, IFA’s Emerging Markets Blended Index, or Vanguard’s Intermediate and Long-Term Bond Funds, the market indexes overwhelmingly dominate the actively managed funds an average of 92% of the time. And some actively managed funds fared far worse. Case in point, in the Long-Term Bond Fund category, the comparison was a knockout blow to active bond fund managers. Sinquefield’s sums up the results of his own studies which mirror these results when he states, “The message is clear: the beat-the-market efforts of professionals are impressively and overwhelmingly negative. In any asset class, the only consistently superior performer is the market itself.”

The third compelling reason that the active vs. passive debate wages on arises out of bad benchmarking. Passive investors conclude that market returns are superior returns. As a result, passive investors buy a blend of market indexes, of market benchmarks, based on risk capacity. Their primary goal is to design and follow an asset allocation that will provide risk-appropriate exposure to markets which have a history of delivering optimized returns. Passive investors have no interest in beating benchmarks. In contrast to passive investors, active investors identify benchmarks that they are expected to surpass. This is faulty logic. The only way to beat a benchmark is to take on more risk than the benchmark, thus rendering the benchmark an inaccurate measuring stick by which to judge active managers. Risk is the source of returns, and taking on more risk is the only way to get more returns. It is also possible however, to take on more risk than the benchmark and not surpass it. This occurs when portfolios are not efficiently diversified and optimized for risk. In either instance, the benchmark is a poor measure to judge active managers.

The chart below represents the investing outcome of a Sample University Endowment Comparison. It is a real-life example of bad benchmarking. It shows the assets of ABC University Endowment with a beginning value of $100 million. The bar on the far left of the chart represents the blended benchmark used to measure the performance of the endowment. The middle column represents the actual growth of $100 million for the endowment. Judging from those two graphs, the managers did in fact deliver returns above the benchmark. However, when compared against IFA Index Portfolio 65, also a blended benchmark with the same equity to fixed income allocation as the university benchmark, we see that the endowment delivered returns far below the more appropriately designated benchmark. This graph illustrates the reason why investors should focus on identifying and allocating to the most appropriate benchmark possible as opposed to selecting a bad benchmark that has little, if any impact on the actual investing methods applied.

Despite the compelling data that clearly and comprehensively expose the folly of active investing, the debate continues. But, it would be wise to consider that, even if we did not have access to the hundreds of studies that comprehensively reveal the inferiority of an active strategy, we would also have to completely disregard the teachings of Adam Smith himself. Sinquefield points out that Smith “was the first to offer a comprehensive statement that markets work and that a free market is the best way for a social order to allocate resources. In his Wealth of Nations he shows that countries with such a system prosper, while those without do not.”

Written in 1776, Smith’s Wealth of Nations argues that free, unregulated economic competition would maximize profits, improve quality and innovation, establish a division of labor and control pricing structure. Smith also established that market competition acts as “an invisible hand” to orderly control pricing and market stability. Smith asserted that no “external designers” are required to control free markets, they function best when left alone to do their job, and he was right.

According to the logic of active investors, Smith’s Invisible Hand does not work so well and mispriced stocks are easy to find. But, we know this to be patently false. We witness the free markets at work every minute of every day. Following the active investor’s reasoning to its logical conclusion, it insinuates that the free markets in which we all participate do not really work, and that there is information known only to a precious handful of individuals—an elite group whose lucky members will invest on your behalf, charging you a larger fee for that privilege. Such a market in which information is made available to a select group of individuals describes an entirely different type of social structure, one that is inherent exclusively in socialist economic structures. Sinquefield asserts, “It is well to consider, briefly, the connection between the socialists and the active managers. I believe they are cut from the same cloth. What links them is a disbelief or skepticism about the efficacy of market prices in gathering and conveying information.”

When you get down to it, the active vs. passive debate remains compelling only when an awful lot of reality is suspended. The simple truth is that market returns are the superior returns. The best way to invest your hard-earned money is to buy a passively managed and globally diversified blend of indexes that matches your risk capacity. You don’t need to try to beat the benchmark, you need to buy the benchmark. Over time, you will be best off by investing in a blend of market indexes. This low-cost, risk appropriate strategy is your best way to earn your share of the returns that are provided by our very profitable free market system, over the long term.

Which blend of indexes is right for you? The answer to that question is the most important determiner of your all-important asset allocation. Index Funds Advisors is an expert in measuring and quantifying risk capacity for individuals, 401(k) plans, institutions and corporations. This important measure enables investors to make sound decisions that can help them earn risk-optimized returns. IFA specializes in the passive rebalancing of risk-appropriate, globally diversified index portfolios that are low cost and efficient.