In praise of active investing
Felix Salmon points us to a column by Mark Hulbert in today’s New York Times. Hulbert reports on Kenneth French‘s effort to quantify the “cost” of active investing, and reports a headline figure of $100B. Felix pulls an excerpt from Warren Buffet’s recent 2007 shareholder letter that serves a great way to frame the issue:
Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.
Buffet, as always, writes charmingly, and the logic here is unassailable. But there’s a subtle point lost in this analysis. Sure, active investors as a class must earn less than passive investors as a class, if passive investors make the same investments in aggregate and pay lower fees. But it does not the follow that active investors, as a class, would have done better had they been passive investors. Why not? Because investors as a whole, including passive investors, would have earned poorer returns without smart active investors setting market prices. If active investors, as a class, accepted the logic that investment expenditures are just costs, all would become passive investors, and the composition of the aggregate portfolio would reflect nothing but noise. My conjecture is that this would impact long-term returns, adversely.
So active investors, as a class, do better than they otherwise would have by bearing the high cost of active investment, even though in doing so they must endure the indignity of being outperformed on average by those who free-ride off their work! It is perverse, under these circumstances, to accuse active investors of squandering $100B, and recommend that we all move to index funds. On the contrary, it is passive investors who ought be discouraged. Passive investors pay none of the costs of generating good investment decisions, but enjoy the benefits by free-riding on the work of others. Their copycatting reduces compensation to those who have earned returns by performing or underwriting informational work. Passive investing also introduces feedback effects and noise into asset prices, rendering the work of active investors more costly and less effective. (See, e.g. information cascades — ht Mark Thoma — and this interesting model of bubbles and crashes — ht jck of Alea — for ways that copying others’ investment decisions as reflected in price moves can lead to instability and error in markets.)
The world of money management is full of shysters and charlatans who’ll take “active investment” fees and do nothing useful with them, sure. But part of that headline $100B “cost” funds real information work, without which markets would devolve entirely to lotteries. Advising people to buy index funds rather than select investments is akin to advising people not to vote, since the cost of voting far exceeds any individual benefit. Those who don’t vote get the same government everyone else does, but at lower cost! A citizenry that takes this reasoning to its logical extreme will get the government it deserves. An investor class that flocks to index funds may soon have the stock market it deserves.
Note: I haven’t seen French’s working paper, which might well have some discussion of these issues.
- 9-Mar-2008, 9:28 p.m. EST: Removed a superfluous “but”.
- 9-Mar-2008, 10:10 p.m. EST: Changed a “his” to a “this”.
Excellent analysis sir. Imagine a pool of investment money in which only one investor was active. And he makes bad asset allocation decisions. Everyone else follows. Value would be destroyed. We need lots of active investors. You can have too many active investors: but when the marginal return from hunting out the best investment falls (active investors will always have a lead time advantage), their number will drop.
March 9th, 2008 at 7:05 pm PDT
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I think some of the ideas you discuss are also addressed in Peter Bernstein’s “Capital Ideas” (I have the 1993 paperback edition).
On p125, in his chapter on Paul Samuelson, Bernstein writes “The good news is that noise trading is the primary motivation for market activity…Noise trading makes the market lively and liquid. People who need cash can raise it readily and those with cash to invest can put it to work promptly. Were it not for the role of noise in creating lively markets, assets would be priced only rarely and with large discontinuities between transactions. The whole process of valuing real assets as well as financial ones, of arriving at rational investment decisions, of raising new capital, and of appraising the future would come to a stop.”
I personally index, based on a clearly demonstrated inability to come remotely close to market returns using my own judgement on buying and selling financial assets.
I think your main point is valid: it’s the willingness of the 80-85% of investment capital seeking excess returns that make it economically successful for the rest of us to make a near market return by indexing.
March 9th, 2008 at 8:43 pm PDT
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So I should practice “no-brainer” investing by buying index funds — and they will only go up? Oh wait — I forgot — they all go up “in the long run”.
Being how an ecnomic downturn is forseeable — why would I go long on stocks? (I am doing great shorting them now) — it will be fun to revisit this in a year or two when all the buy-and-hold index investors have been vaporized.
March 9th, 2008 at 10:12 pm PDT
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Steve,
You got a mention in Paul Krugman’s column today!
It’s time you were recognized!
Donaldo
March 10th, 2008 at 12:36 am PDT
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JoeD, Andrew, and ECP — I think we’re mostly agreeing, so woohoo. I overstate the case against index funds sometime, I think it’s okay to choose to index sometimes, but as ECP says, choosing to index all the time is both informationally bankrupt and an invitation to turmoil if much of the world ends up holding basically the same position. The necessity of “noise trading” to liquidity is something I like to think about. It’s hard to characterize just who are the noise-traders in current lively markets, and there is the old fashioned notion of dealer-provided liquidity. Then there are more exotic ways of providing for market liquidity without requiring spontaneous, presumed noise traders… I’ve some ideas on that, hopefully a post soon.
Donaldo — Thanks for the kind words, and for pointing out Krugman’s cite. I had no idea. I’m kind of terrified…
March 10th, 2008 at 8:21 am PDT
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Steve, I have to say I’m unconvinced by this reductio approach. “If A then B” statements are all true if A is false. And so when you talk about “if everybody became a passive investor”, it all just seems academic. If everybody became a passive investor, pigs would fly. You yourself say that you’re taking things to a “logical extreme” — is that really useful or germane?
March 10th, 2008 at 10:58 am PDT
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Felix — Fair enough. Somewhere between “everybody independently values and selects securities” and “everybody just does what everybody else is doing” bad things start to happen, including poor real world capital allocation, low long-term financial returns, and chaotic (“bubblicious!”) price action. We don’t really know the details of the transition, whether it’s gradual or a tipping-point kid of thing, at what fraction of investors going passive the costs get serious.
It’s a lot like greenhouse gasses, really. Tallying the aggregate “costs” of active investing is like enumerating the costs of reducing CO2 emissions without figuring in any kind of benefit. Advising people to go passive is like telling people to ignore their carbon footprint, because by doing so you’ll come out ahead of those who conserve (you’ll live in the same world, but bear fewer costs).
Scolding people not to go passive may be a fool’s errand, so long as the individual cost/benefit looks good. But broad encouragement of behavior that has clear (if hard to quantify) external costs as though it were a virtue, because, hey, it won’t cost you anything, strikes me as a bad idea.
March 10th, 2008 at 11:52 am PDT
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Alpha doesn’t exist, just risk and luck
Passive investors can invest in all sorts of asset classes that automatically get rebalanced at the end of every period. There is lots of public information other then index prices that passive investment funds can track to build there portfolio, EBITA, revenue growth, income growth, estimated eps, dividend etc.. Passive funds can target certain industries and countries. Passive investing is not just following the S&P.
Of course Buffet is the *proof* of the existence of alpha. If you can identify the next Warren Buffet you by extension have Alpha but since you can’t (or anyone else for that matter) Alpha doesn’t exist.
March 10th, 2008 at 11:19 pm PDT
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Although I agree with you in principle, Steve, I suspect you’ve attributed far too much complexity to this topic. $100Bn is not “squandered” but spent. Now, some spend that money wisely; generating far greater returns than their index brethren, with the added expense simply a decimal point on substantially higher investment profits. On the other hand there are those who are either being “taken” — charged fees way out of proportion to the returns they are receiving, or are simply fools, gambling on speculation, emotion, slick advertisements and the like.
Yet this is the price of freedom. True, the advice given to the average consumer by investment houses, brokers and mutual funds alike, is generally poor. Slogans, such as “investment is for the long term”, “lower fees mean greater return over time”, “dollar cost averaging generates the greatest return” are all somewhat misleading. If there is any need to rein in our investment houses and their fraudulent advertising, this is one area that deserves attention.
Warren Buffet, on the other hand, is at times, simply dead wrong. Listening to him is akin to obtaining computer advice from Bill Gates. Just because he’s successful doesn’t mean his ideas or products are superior. Your quote from Buffet: “Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.” is embarrassingly foolish. Unless, of course, he’s making a sales pitch for index funds.
Yes, my returns are diminished by a far greater percentage than passive investors. Then again, my returns are many multiples of that passive investor group. I’ve reached a point where I don’t look at fees and simply don’t care. I pay for performance, and the amount I pay, while it may contribute to that $100Bn, is insignificant compared to the added return I gain. Period.
The only problem, and the issue that Professor French raises, is that too many people, with too little knowledge of the markets, economy, momentum, business fundamentals and market psychology among others, recklessly chase returns having little idea of how to go about it. Yet, if there are some investors who want to treat Wall Street like the baccarat tables in Monaco, that’s their right.
I would suggest that we expend greater efforts to educate the masses, and at the same time, simply leave the rest of us alone to make our fortunes.
Jack Heismann
March 11th, 2008 at 12:48 am PDT
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I think the author is missing the point. The main activity of active investors is not guessing which stock is truly a better stock than another one. The main activity is guessing what all the other investors will do. 95% of market movement is not related to fundamentals at all.
And commenter Heismann truly misses the point. Inexperienced investors may win or lose. But the stats show that the most experienced and knowledgeable investors, the guys charged with investing millions of bucks and who have all the info and who spend all day every day perfecting their abilities…. those guys underperform passive funds. The ones who are making their fortunes are the ones who are invested in index funds.
March 11th, 2008 at 10:02 am PDT
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All — Sorry for being slow to respond.
Chico — Getting the definition of passive investing right is important if we’re gonna argue about it. I agree with you that there’s a lot of flexibility in what you do with indices. I’d try to break the perceived equivalence between use of indices and passivity. If I had to define passive investment, it would be defining an asset allocation based on broad historical performance patterns and personal circumstance without incorporating any substantative view of future performance other than the broadly extrapolated past. To be active, in my view, implies taking bets about future relative performance, either of assets or managers. The means are less important.
Jack Heismann — I find little to disagree with in what you say. I’ve got to do a better job of articulating why the passive investment trend bothers me. As you say, active investors can still do our thing and reap our rewards, and Buffet’s setup (which I took as given and responded to on its own terms) is inaccurate, passive and active investors don’t hold the same portfolios in aggregate, except arguably those who confine themselves to listed equities. I do agree that most people are unlikely to “beat the market” unwise, because it’s not their comparative advantage (e.g. people get ripped off and do stupid things) and not worth the effort to make it so given a low base of capital. What I object to isn’t indexing per se, but the claim that choosing well-known stock indices as a default investment choice is a good idea because it would have been a good idea in the past.
Anon — I’m very familiar with the literature on mutual fund performance. I agree that lots of stock movement isn’t based on fundamentals. Neither of those points suggests that passive investing is better than active for the patient, unconstrained, smaller investor. I think commenter Heismann and I are willing to let it be an empirical question.
March 12th, 2008 at 5:32 pm PDT
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To go with Chico, most indices are composed of the biggest capitalizations available and rebalanced periodically to take out “loosers” and bring in “winners” of the capitalization game.
So investing in indices is betting that in the future the big guyes will do better than the small and that staying diversified on N names is a good idea.
Not that “passive” nor “stupid” in the current context, and it’s worth many other macro bets about the future so I wouldn’t disqualify it as “without incorporating any substantative view of future performance”.
March 16th, 2008 at 10:25 am PDT
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