• The eternal Rivalry in Portfolio Management
• A portrayal of both strategies
• How did the rivalry started
• Major Critiques against Active Investing

There is a rivalry in the investment world that matches the ones that we experienced, and still experience, in sports:

• Muhammad Ali vs. Joe Frazier II.
• Michael Jordan vs. Kobe Bryant.
• Roger Federer vs. Rafael Nadal.
• Leo Messi vs. Cristiano Ronaldo.

in science:

• Robert Hooke vs. Isaac Newton.
• Sigmund Freud vs. Carl Jung.
• Nikola Tesla vs. Thomas Edison.

in business

• Coke vs. Pepsi.
• Microsoft vs. Apple.
• Adidas vs. Nike.

and in general!

• Good vs. Evil.
• Reason vs. Emotion.
• Cats vs. Dogs.
• Star Wars vs. Star Trek.

You may be thinking about the rivalry between Value Investing vs. Growth investing, but this is not the one. I think that Warren Buffet already taught us that growth is one of the variables that a value investor should include in the assessment of investment opportunities. However, the following two statements made by the Oracle of Omaha can serve us to get “dirty” in the rivalry that we are discussing today.

“Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy.” 

“If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the wears and whose principal would grow as well.”

Ladies and Gentleman, today we are discussing Active vs. passive investing, so sit back, relax, and enjoy the reading!

A quick portrayal of both strategies

 Active Investing 

A variety of investment strategies in which the portfolio Manager tries to outperform a particular benchmark index. Active managers rely in the in-depth analysis of different factors in order to select their securities. The different analyses that active managers undertake translate in high costs for the investors.

Passive Investing 

How did the rivalry begin?

You already know about the Nobel Laureate Harry Markowitz, I introduced it in the post Yes We Can… Diversify, because he was the one who demonstrated mathematically how diversification works. However, I didn’t mention the assumptions that his Modern Portfolio Theory (MPT) make. MPT assumes that the stock markets are efficient, which means that stock prices are a fair representation of the true value of the companies, and it also assumes that investors are rational and “profit-maximizer” creatures.

If this is true, no one can regularly beat the market, and any active manager that beats the market would be just a matter of statistics, of luck. This means that passive investing is the way to go and that active investing performance would not only be a matter of luck, but a complete scam, since managers are charging fees for something that has a value of 0.

Active Investing is still the most popular strategy, and MPT has been around for over 60 years, so as you can imagine, its not widely accepted in the practitioners world. The theory has been disputed through the years in the scholar world as well, and quite vigorously after the appearance of Prospect Theory.

Prospect Theory was first introduced by Daniel Kahneman and Amos Tversky in 1979. This work will result in a Nobel Prize for Daniel, but not for Amos (he died in 1996, 6 years before the concession of the price). The theory describes the decision making process when there is risk involved. This study was pretty much the beginning of a movement that is known as behavioral economics that studies the effects that different factors such as psychological, social, cognitive, and emotional, have in our financial decisions, and ultimately, their effect in financial asset prices and returns.

These factors make humans irrational and prevent them from being “profit maximizers” as Markowitz claimed, and what is most important, paint a completely different picture on the price of financial assets. Since investors are not rational, the market prices won’t be a fair representation of the companies’ value and hence there is room for those active managers that understand human behavior and can take advantage of the irrationality of the masses.

Major critiques against Active Investing

 It is quite important to keep in mind that active management is the incumbent in the investment world, and that passive management is the new entry (not that new anyways). This is why most of the criticism has come from the passive investment proposers and targeting the active managers.

Here the major criticisms of active investing:

Markets and security prices are unpredictable:

There is a large number of financial advisors, mutual fund managers, hedge fund managers, asset managers, etc, that are currently making calls on where a particular stock, asset class, or market is going to be in the future. It could be that those calling the right moves would do so due to luck and not to skills. This is what some of the biggest opponents to active investment believe, and these ideas seem to be backed up by reliable research.

Kent Smetters, a professor at the prestigious Wharton Business School states that the investment managers that outperformed their benchmark in any given year are still likely to underperform in the following year. In his own words, “In fact, outperformers had only a 20% change of repeating the following year, and …just a 10% chance of outperforming three years in a row.”

However, the fact that the outperformers are still likely to underperform in following years might not exactly imply that they are not able to forecast the future. The portfolio managers can suffer from diseconomies of scale due to too many assets coming into their portfolios, or they may raise their fees if they feel that they deserve a bigger cut of the returns. All this will affect the future capability of outperform the benchmark.

Similarly to the argument that markets are unpredictable is the one that future prices are random. Numerous studies have failed to differentiate stock returns from random walks with a drift. We explained this in our post Stocks and boats – What do they have in common? What does this mean? That there is not statistically prove that stock prices can be predicted, and that portfolio managers that beat the markets are just the lucky ones.

There is an interesting counterargument that can be used here. I found it in the web RetailInvestor.org, here the link to the post ActiveVsPassive.

The counterargument states that assuring that the performance of the managers that actually beat the markets is due to luck because it fits a statistical model that shows they could be due to lack, it’s not actually proving that they are due to luck, it is just failing to prove that they are due to something else. RetailInvestor.org says it in a simpler way, “The argument is invalid because it simply PRESUMES. It does not prove.”

The cost of active management

The costs in active management funds piles up.

• Trading costs.
• Higher taxes due to high turnover rates.
• Commissions.

In average the cost of active management stays well above 2% per year, while for passive index is around 0.3%.

Active managers are force to outperform passive managers by at least 2% per year in order to be equally valuable for an investor, but do they? 

Active Managers underperform Passive Managers

It seems that they don’t. There are multiple studies that show how the average active manager underperforms her passive counterpart. Academia has been eager to research about this topic, and there are dozens of studies covering different periods, using different methodologies and different types of active funds. Most of the studies come to the conclusion that the average active manager underperforms the benchmark after fees are subtracted.

Note: If you want to find the research demonstrating my last paragraph, start by going to Google scholar and typing active management vs. passive management. You can spend a whole weekend reviewing papers!

There is however an exception. It seems that the value of active management depends extensively in the efficiency of the underlying market and in the sophistication of the investors that participate in those markets. In the paper “Does Active Management Pay? New International Evidence” written by Alexander Dyck, Karl V. Lins, and Lukasz Pomorski, there is evidence of the importance of efficiency in the underlying market in addressing the worth of active strategies. While in U.S. markets (relatively efficient) the active manager under performs, in emerging markets (relatively inefficient) it outperforms by more than 1.8% per year in the period between 1993 and 2008.

Passive Management proves to be the best alternative, in average…

What the previously discussed points tell us is that passive management should be the first choice for most institutional investors and for every single retail investor. We cannot prove that the outperformance of some active managers is due to luck and not due to skill. However, the impossibility of discerning if it is one or the other makes it quite hard to separate the ones that are lucky from the ones that are talented. At least for the vast majority.

One thing is certain though, if passive managers tend to outperform active managers, but active managers are still managing greater amounts of money than passive, investors cannot be rational and markets cannot be efficient. Markowitz might have been a little wrong…

If the markets are not efficient, what are they? Well, that’s the topic for another post.

I hope you enjoyed the read, and as always if you want to discuss anything, comments and emails are more than welcomed!

OpSeeker – Contributing to financial literacy

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