Passive investing

Lately, I’ve started to read/watch more stuff about financial economics (William​ F. Sharpe, Eugene F. Fama, etc), and I discovered very interesting quote that justifies the passive investing by an average investor:

“If there are smart active managers making money, they have to make money at the expense of poor active managers, because passive managers are out of the game - they don’t respond to the actions of active managers. That’s not a hypothesis - that’s arithmetic. That has to be true. Every point in time that has to be true. It’s the most fundamental proposition about active management that you can have. Bill Sharp calls it ‘arithmetic of active management’ just to emphasise it. It’s not a hypothesis, it’s arithmetic. And it’s the toughest concept to get people to swallow. It’s like - you can’t get them to swallow that 1+1 is 2. It’s mind-boggling.” (Eugene F. Fama)
https://youtu.be/nS6HAzOEJgM?t=150

In fact, William F. Sharpe says something similar in this interview:
https://www.bloomberg.com/view/articles/2017-06-06/william-sharpe-on-pricing-and-risk

He says something like that: There are three types of investors: smart (winning active managers), dumb (indexers) and really dumb (losing active managers). If dumb become less dumb and move to index investing, this will be game over for smart investors. By “smart” he means those smart beta investors, who underweight growth stocks regularly overpriced by dumb investors.

The more I read about this stuff, the more I get convinced that to successfully active manage investments, you have to have two things: (1) luck, (2) huge resources. If you don’t have these two, in long term you just voluntary transfer money to those that have these two things.

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There is no doubt that for the investor who does not want to spend too much time in investing or is not sure about what he is doing, passive indexing is the most efficient thing they can do.
By indexing, you piggyback on the economy and you get whatever result the underyling economy will provide.

There is also no doubt that for every winning active manager, there will be one losing active manager.

However, I disagree with this :

If almost everybody goes to passive indexing, they are not piggybacking on the economy, they become the economy.

Let’s do a thought experiment and assume 99% of investor are indexing. Then there are mathematically much more buyers than sellers, since indexing is a buy and hold strategy. Then you have two consequences :
-The price of each share in the index invested by ETFs will go up, because everybody wants to buy them, and this, without any regards to the quality of the underlying business. This leads to a situation where every share that is in an investible index ETF is massively overpriced.
-On the contrary, any share that is not in an investible ETF will be massively underpriced because there is almost no buyer for them.
In other words, there is not any mechanism of price discovery anymore at this stage.

Eventually, some investors will realize that the dividends they are getting for the price of their shares are becoming lower and lower and that they are getting no returns since the price of their shares has become disconnected to the underlying businesses. They will start selling again , inducing a massive correction in the price of the index and massive losses for indexers.

In this thought experiment, the smart investors have just to buy the stocks not present in indexes and wait for dumb investor to realize that the index are too expensive and that they move again to other stocks.

In other words, if everybody goes investing, there will be a massive ETF bubble.

That is why I think it is a paradox to wish that everybody goes passive. If we want to be successful passive investors, we should not wish that everybody else does the same thing.

Michael Mauboussin was saying that in order to have efficient markets (a very important assumption for indexing), you need three conditions :

1 - A great diversity of different investors, with different opinions : true most of the time.
2 - A mechanism that enables to aggregate this diversity of opinions : this is the price of every share
3 - An incentive to be right : if you are right you win money, if you are wrong you lose money

Conditions 2 and 3 are almost always true. However, if everybody goes passive, condition 1 is not valid anymore.
When you have a lot of different opinions and you aggregate them, the errors tend to cancel each other and the general consensus tends to be quite effective (“wisdom of the crowd”). However, when everybody in the crowd has the same opinion, the errors don’t cancel each other but rather tends to add to themselves. (“Madness of the crowd”)

That is why I think it is very important that not everybody goes passive, or else you will have a massive bubble.

Finally,

The more I read about this stuff, the more I get convinced that to successfully active manage investments, you have to have two things: (1) luck, (2) huge resources. If you don’t have these two, in long term you just voluntary transfer money to those that have these two things.

I agree that being a successful active investor is very difficult, however I am not sure if I agree with your two points.
Although some of the successful ones can of course benefit from luck (survivorship bias), I think there are enough counterexamples proving that luck was not involved in the success of all of them :
-For instance, Edward Thorp had positive returns 227 out of 230 consecutive months. if this was due to luck alone, we would estimate his chances to 1 out of 10 power 63. To put this probability in context, the odds of randomly selecting a specific atom in the earth would be about a trillion times better. Boy! this guy was lucky.
-In his famous article The super investors of Graham and Doddsville, Warren Buffett asks and explains brilliantly what is the part of luck present in the returns of many successful investors.

To be a successful active investor, Howard Marks says you have to :
1- Look at what is the general consensus
2- Say when the consensus is wrong
3- Be right

Part 2 and 3 are incredibly difficult.

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I am currently re-reading Early Retirement Extreme by Jacob Lund Fisker, and by chance I stumbled upon this passage, quite relevant to the topic :

Buy and Hold is an investment strategy with no exit strategy. What this typically means is that stocks are usually liquidated when money is needed, rather than taking into account when a given stock is overvalued. The aggregate effect of workers investing in this manner is to turn the stock market in an elaborate demographical Ponzi scheme, where the value of investments depends on how many people are retiring and how many people are entering the labor market. In particular, it depends on the level of confidence that the most recent entrant has in the system, and hence it becomes a policy matter.(…) If stocks are supplied and demanded according to how many are entering and leaving the workforce, then market price become dependent on demographics.

So in short, if an investor wants to do passive indexing, it is very important that not everybody else does the same, or very stinky side effects can happen. Given the age pyramids in western countries, demographics would not work in our favor if everybody goes passive.

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Thanks @Julianek for your response. I agree with you that it would be bad for us if everyone went passive. I don’t agree however that this justifies active investing. Clearly, the thesis that successful long-term active investing is impossible is an overstatement because we have examples of lucky geniuses that managed to beat the market over very long time. The questions is, however, what’s the rate of long-term successful active investors to unsuccessful active investors. And how probable is that we can become long-term successful active investors. After reading Fama, Sharpe and other financial economists, I personally think that there’s hardly any chance.

It’s a scientific consensus in financial economics now that active management (deviations from the strategy to exploit short-term opportunities) is not able to deliver consistent positive returns after costs. It’s a zero-sum game after all because in the long-term, portfolio returns are mainly driven by their underlying risk factors.

There are several empirical studies that prove this point:

  • Brinson, Hood, Beebower (1986)
  • Brinson, Singer, Beebower (1991)
  • Drobetz, Köhler (2002)
  • Vanguard (2003)
  • PPCmetrics (2014)

Exactly, beat the market after cost on a long period is quiet impossible

Very interesting topic… My conclusion is that I will stop telling people about ETFs and start telling them to invest in whatever fund their bank runs. Got to do my part to keep the market going! :stuck_out_tongue:

@Julianek, thanks for that passage, it’s very interesting. Does the book go on to recommend an exit strategy or some sort of solution to that problem?

If you go to the Bloomberg, Financial Times or any other market news website, you’ll see that 90% of ETFs articles are talking about ETFs becoming too popular, too big and this will cause some issues in the future. I think this is exaggerated - it looks weird though that are now more ETFs than stocks. Some time ago I’ve seen a chart showing the proportions of actively managed funds to passively managed funds, and, of course, the rate active ones is dropping a lot. But still I think, that we’ll never reach a point where there will be not enough active investors to set the prices for stocks - because we’ll never run out of smart, ambitious investors - like @Julianek - who want to beat the market.

I actually think that this trend is healthy - most of the people should go with passive, index fund. Small minority should be dedicated to find ways to beat the market, even though bigger part of that minority (after cost and in long run) will fail. I think it’s a healthy equilibrium.

Additionally, I think that there will be always risk-avarse people who prefer higher risk-adjusted returns over normal returns because they have no stomach for dropping their portfolio in half during big recession. This will always produce a niche for actively managed hedge funds (although most of them fail to provide even better risk-adjusted returns than the market). Still I think there are many people who just can’t bear the stress and they’ll go for shitty returns in exchange for low volatility.

Here are some examples of actively managed funds which have beaten sp500.

http://www.odysseyfunds.com/funds/growth_fund.html
http://www.odysseyfunds.com/funds/aggressive_growth_fund.html

"The picture that emerged once S&P did that was sobering, to say the least. Over the last 15 years, 92.2% of large-cap funds lagged a simple S&P 500 index fund. The percentages of mid-cap and small-cap funds lagging their benchmarks were even higher: 95.4% and 93.2%, respectively.

In other words, the odds you’ll do better than an index fund are close to 1 out of 20 when picking an actively-managed domestic equity mutual fund."

“Over 10 years, 83 per cent of active funds in the US fail to match their chosen benchmarks; 40 per cent stumble so badly that they are terminated before the 10-year period is completed and 64 per cent of funds drift away from their originally declared style of investing.”
https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-e7eb37a6aa8e

Every 5 years there’s ~20-30% of such funds (in 10 years ~12% and in 15 years ~7% of funds beating their benchmarks). The trick is that every few years these are different ones - so there’s definitely huge part of luck in that process. Here you have summary of a research that shows that:

Since most of us is planning to invest more than 10-15 years, there’s no point in risking so much to have 7-12% of chance that our fund will beat the index. It’s more rational to stick to the index, with lower costs and guarantee that we will have result equal to benchmark that most of the funds can’t match.

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As you pointed out, most of the actively managed funds underperform their benchmark. However, this does not mean that there are not any actively managed funds which outperform their benchmark consistently (e.g for 20 years). Everyone needs to do their due diligence before choosing a fund.

That’s true some (really few) funds overperform the benchmark on the long run, but you don’t which one.
Past performances don’t predict future performances. Even with due diligence, the likelihood to chose the correct one is low.

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If over 15 years only 7% beat the index - what must be the rate over 20 years and since last 20-years winners almost certainly won’t be the new winners for another 20 years, what is the chance that you’ll choose the next winner? Hardly any - there’s more to luck here than to doing due diligence.

I think the only rational strategy with actively managed funds is to invest in 5-year intervals in a new fund - then we have at least 20-30% of chance that we’ll beat the index. Sticking for 20 years to one active fund instead of a passive one is pretty much crazy.

If someone thinks that beating the benchmark consistently for 20 years is attributed to the portfolio manager’s alpha, then she has a reason to invest in actively managed funds.

If she thinks that beating the benchmark consistently for 20 years is attributed to luck, then index funds are better choice.

I’m not sure if your winners with blessed alphas will remain winners in next 5-10-15 years. As S&P’s SPIVA report points out: “An inverse relationship generally exists between the measurement time horizon and the ability of top-performing funds to maintain their status. It is worth noting that no large-cap, mid cap, or small-cap funds managed to remain in the top quartile at the end of the five year measurement period. This figure paints a negative picture regarding long-term persistence in mutual fund returns.”

@Alex, Unfortunately Jacob does not give any exit strategy, be it in his book or on his forum. I think part of the reason is that he wanted the global philosophy that he describes in the book to be independent from any external event like a bull market or a given investment scheme. However, the way the passage is formulated (“rather than taking into account when a given stock is overvalued”) makes me suggest that Jacob does some sort of value investing : buying when an asset is a bargain, and selling when it is overvalued.

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I feel that when we talk about passive investing, several trends have to be differentiated :

  • The good old Vanguard way,on a very broad market, with low fees, very low turnover, the way it was meant to be done. This is what everybody thinks of when we say “passive investing”

  • On the other hand, Wall Street was not slow to find out that investors have started to do more indexing. Therefore, they created ETFs for every index imaginable, with usually much more higher fees.() And I feel like a lot of retail investors are going to these ETFs, the ones that are usually proposed by your banks. And sadly, the fact that these indexes are market cap weighted introduce a lot of valuation distortion.
    (
    ) For instance, I have found this very interesting video. Disclaimer : the guy is an active manager, so what he says has to be taken with a grain of salt. However the fact that he is praising Bogle seems like a good sign. In a nutshell, he describes the excesses caused by the ETF industry (as opposed to the indexing mutual fund industry).

The transcript can be found here.
(By the way, after viewing the video, it would be interesting to know which percentage of your portfolio is composed of Exon Mobil :slight_smile: )

  • In the last years, central banks like the Swiss National Bank or the Bank of Japan, in order to protect their currency, have started a massive amount of foreign assets purchase. In 2015 for example, the SNB purchased 61 billions $ of american ETFs. Which makes it de facto the 4th largest ETF in the world. If such a trend continue, no amount of active investor will be able to counterbalance the volume of purchase. The price discovery mechanism would be then broken.

  • Finally, among all the retail investors, how many have never seen a bear market? It is easy to say they will never sell, but history proved many times that they did exactly the opposite during last few crashes. If this happens with ETFs, this phenomena can be more problematic.

My goal is not to criticize passive investing. It is just to raise awareness of its limitations when Wall Street industry and central banks are pushing the button up to eleven. A lot of investors on this forum are beginners (this is not a critic), and I really think passive investing is a truly healthy basis (when done in the Bogle style).
But sometimes the amount of faith I see on this forum (and on the MMM one as well) kind of upsets me : it is not a silver bullet and it is far from being riskless.

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In my opinion the big issue with active managed funds is the industry’s structure, in particular the incentives created by the management fees.

What is the goal of a fund manager, when the fund charges 2% of assets annually and 20% of performance (like it can be the case for most hedge funds)? Growing your money or growing the total number of assets under management? For sure it is the latter.

Add to this the agency problem. Usually the fund manager is just an employee in the fund company, and like everyone else, he’d like to keep his job.
In that context, fail conventionally and you’re okay; fail unconventionally and you’re fired; win conventionally and you’re okay; win unconventionally and you’re a genius. Mutual fund advisors that wish to keep their jobs tend to flock together and behave like a herd. One of the consequence is that they will never be too far from their benchmark. However, if you add the fees into account, no wonder why they lag the market.

I wonder how the statistics would be if we keep only the funds charging only performance fees with hurdle (that means, they charge fees only if a satisfactory return has been reached for the year). If we look at all the successful active investors - Buffett, Guy Spier, Pabrai, Klarman and so on- , they all have the same incentive fees structure : no fees until 6% have been reached for the year, and then 20% of the performance. If the fund loses money, no fee is charged until the fund’s valuation reaches once again its highest historical valuation. That seems to play a big role in a fund performance. In that way you can be sure that the fund manager’s incentives are aligned with those of the investor.

Ah, also, in my opinion it is also fundamental that the manager eats its own kitchen and has a big skin in the game. If the manager has not a very important part of his wealth invested in the fund, it would be a red flag to me.

Sorry about digressing too much about the initial subject :smiley:

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here another reason for passive indexing:

anybody has such a chart for a longer time span?^^
since this is only 10 years. including the 2008 crash…

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That graph argues more against passive investing: asset allocation is still up to you in passive and it shows how much and how often you get screwed by choosing a wrong asset class

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