![]()
PART I
THE ACTIVE VERSUS PASSIVE DEBATE
![]()
CHAPTER 1
Framing the Debate
I canât believe that the great mass of investors are going to be satisfied with just receiving average returns. The name of the game is to be the best.
âEdward C. Johnson III
The investment management business is built upon a simple and basic belief: Professional managers can beat the market. That premise appears to be false.
âCharles D. Ellis
The active versus passive debate has all the drama of West Side Story, complete with larger-than-life characters and Shakespearean tragedy. Like two rival gangs, the Jets and the Sharks, vying for control of the streets, alternating between dominance and demonization, the opposing active and passive gangs fiercely defend their ideology as they fight for the hearts and minds of all investors. The gangs grapple with each other in the media and needle one another during public speeches and at industry events. No physical brawls have broken out yet - at least that I am aware of.
The tragedy, as passive investors would explain it, comes from the seemingly utter failure of active managers to deliver on their promises of market beating results while enriching themselves with fees extracted from investors who entrust money to them. Active advocates counter that it is possible to beat the market and point to icons such as Warren Buffett as proof. They believe their own superior knowledge and intellect will also lead to above the market returns.
Whoâs right and whoâs wrong? To answer this, the opinions of educated and unbiased professionals are needed. This leads us to the halls of academia and to research institutes that study and interpret performance data. Not just any academic or institution will do, because many researchers side with one gang or the other strictly for monetary reasons. They are either paid to write reports that agree with a gangâs thinking, or in some way participate in fees and services offered by one side or the other. Unbiased academic opinions are needed from people who arenât compensated by the investment industry. Rather, they exhaustively seek the truth without any preconceived conclusions and make their findings public for the world to judge.
The references to books, articles, and academic studies throughout this book are just a starting point for people interested in this area of study. Sourcing these references leads to a rich treasure chest of data, analysis, and opinion from many of the worldâs greatest financial minds.a
In the Beginning, There Were Active Funds
This book is about mutual fund investing and portfolios of mutual funds, although the arguments can be extended to portfolios of individual securities. Mutual funds are the main focus because they are the optimal investment vehicle for most people. Mutual funds offer diversification, reasonable fees, and liquidity when needed. In addition, there is ample public information available on mutual fund analytics, and that helps in analysis.
The first U.S. open-end mutual fund began operations in Boston, Massachusetts in 1924. The Massachusetts Investorsâ Trust was a wonderful idea. The new structure offered broad diversification of securities that individual investors couldnât obtain on their own for the same cost. The fund also offered investors full liquidity in mutual fund shares whenever they needed it. Other companies soon followed with similar fund offerings.
In the early years, mutual fund companies werenât in business to beat the market. Rather, their mission was to select superior securities that paid reasonable dividends, to secure profits without undue speculation, and to conserve principal.1 One reason that beating the market wasnât a goal is because there were no broad based indexes available at the time. There was the 30-stock Dow Jones Industrial Average, but this was a price-only indicator that didnât reflect the entire market of securities or its economic value.
The fund industry reasoned that mutual funds existed to provide all investors the opportunity to own a diversified securities portfolio at a relatively modest cost. The commissions and other trading expenses that an individual investor would expend building the same diversification with individual securities would exceed the cost of the mutual fund shares. According to one source, to buy one share of each of the securities in the 30-stock Dow Jones Industrial Average would have cost $1,800.81 in 1951 with the commission charges on the purchase and resale of shares amounting to 11.16 percent of their purchase price.2
From an investorâs standpoint, mutual funds were a fair deal. Most people didnât have enough money to buy several dozen stocks, and they didnât have the expertise to keep up with their portfolios. Even the United States Supreme Court agreed. Louis D. Brandeis, Associate Justice of the United States Supreme Court commented:
The mutual fund system worked for the industry and for investors for many years because it was a win-win situation. Investors bought into a diversified portfolio of securities through mutual funds, and the fund companies didnât need to be concerned about losing assets when their managers underperformed the markets because few people monitored the returns that closely.
Passive Investing Makes Its Case
The cozy relationship between Wall Street and Main Street lasted for several decades. Then, in the 1960s, a barrage of brash, young academics began to analyze mutual fund returns more closely and started asking tough questions.
These academics were smart and talented, but they werenât altruistic. Their purpose for deep analysis of fund performance wasnât to discredit active investingâquite the opposite. They were seeking a way to identify investment skill among managers so they could copy those methods and use it for profit. Like everyone else, the academics thought if they dug deep enough, their research would lead to a way to consistently beat the market without taking more risk.
Identifying profitable investment strategies proved harder than it appeared, and what the academics found was much different than what they wanted to find. The details of these early academic studies are the subject of Chapter 2. In brief, the data suggested that few active managers actually beat the markets after adjusting for risk, and that luck couldnât be separated from skill. The academics also started to theorize that most investors would be better off just buying the market itself if they could.
The academics brought their findings to the fund companies. The fund company executives were as unimpressed with the academic research as the academics were with mutual fund performance. When the academics questioned the lagging performance relative to the markets they were quickly reminded by fund company spokesmen that âyou canât buy the market.â4 This was a true statement at the time. Index funds didnât exist.
Now You Can Buy the Market
The world changed in 1976 with the introduction of a passively managed S&P 500 index fund by the Vanguard Group. This gave mutual fund investors an option; they could continue to invest in actively managed mutual funds that tended to underperform the market by a considerable amount, or they could buy very close to the market return through the First Index Investment Trust (later renamed the Vanguard 500 Index Fund).
The introduction of index funds to the marketplace was an inflection point in mutual fund history. Not only did index funds give investors a choice, they forced active fund companies to redefine their purpose. When asked if Fidelity would follow Vanguardâs lead and offer index funds, Chairman Edward C. Johnson III stated, âI canât believe that the great mass of investors are [sic] going to be satisfied with just receiving average returns. The name of the game is to be the best.â Another large fund company responded to the challenge in a flier asking, âWho wants to be operated on by an average surgeon, be advised by an average lawyer, or be an average registered representative, or do anything no better or worse than average?â5
These public statements by active fund companies signaled a titanic shift in industry ideology. For the first time, fund companies took the stand that it wasnât enough to simply offer diversification through a pooled basket of securities that investors couldnât achieve on their own at the same cost. The new mission was to beat the market.
Benefits of Passive Index Investing
In 1976, the active versus passive debate spilled over from academia onto Main Street. On the surface, the active fund industryâs decision to go head-to-head on performance against index funds was noble. They were determined to beat the market, and they actually thought they could do it. Unfortunately for the active managers, the economics didnât work. The costs were too high, the competition too intense, and there was too little talent among fund managers.
Fortunately for the active managers, the general public didnât know these facts and still doesnât know these facts. Many people continue to believe that the active managers they select will win. Hard facts should have put this debate to rest a long time ago, but it continues to rage on in the battlefield of public perception.
Wise investors know that when one investment strategy can achieve a financial objective with more certainty than another investment strategy given the same risk, they should opt for the strategy with the highest probability for success. Decades of return comparisons and scores of academic studies show passive portfolio management is that strategy.
The benefits of passive management using index funds are numerous. First is the cost. The fee for passive management in a mutual fund is much lower than active management. A fund company typically licenses an index from an independent index provider for a nominal fixed fee or a portion of the assets under management in the fund. In contrast, the active funds must pay economists and analysts to figure out which asset class, which countries, which industries, and which securities to buy and sell. This difference in labor costs keeps the expense ratio for a passive fund very low compared to an active fund. A fund that tracks an index may charge only 0.2 percent in annual fees compared to an active fund with the same investment objective, which may charge 1.2 percent per year.
Bond index funds also operate at a greatly reduced cost structure over actively managed bond funds for the same reasons. The typical bond index fund is about 0.2 percent compared to the 0.9 percent annual cost of an active fund. These figures donât consider sales charges or commissions that an investor may have to pay to purchase or sell funds.
Taxes are another important cost for many investors. Capital gains are distributed to mutual fund shareholders each year based on the net gains from securities sold within each fund. Indexes tend to have low turnover, so index funds have relatively low annual distributions compared to active funds. Distributions from exchange-traded fund (ETFs) are even lower than traditional open-end index funds due to their unique structure. For detailed information on ETFs, including tax benefits, read The ETF Book by Richard Ferri (John Wiley & Sons, 2009).
Itâs interesting to note that active fund turnover was much lower in the years prior to the introduction of index funds. Turnover started rising when active funds started to compete with index funds on performance. In fact, turnover in the active fund industry is about 15 times higher today than what it was in the 1960s.
Thereâs only a finite amount of wealth thatâs earned in the financial markets each year. Accordingly, the cost to invest has a direct bearing on each investorâs return. Since the cost of active management is higher than passive management, after all costs, the average actively managed dollar (or euro, yen, etc.) must underperform the average passively managed dollar (or euro, yen, etc.) in a market. This is according to William Sharpe, Stanford professor and Nobel Prize recipient. Itâs simple arithmetic, and itâs the basis for all arguments that say index funds must outperform active funds in the future.6
All about Indexes and Benchmarks
Not all indexes are created equal. There are many different types of indexes to choose from and the selection grows each year. Accordingly, an explanation is needed about index construction before any logical case for index funds and ETFs that follow benchmarks can be made.
An index is a generic term that describes a list of securities that are selected and weighted according to a set of rules provided by an index originator. The index company publishes the price level and the performance of their indexes daily, along with its constituents and any changes to those indexes.
Benchmarks are market tracking indexes that most people envision when they hear the word index. These are broadly based representations of market activity designed to track the value of financial markets or secto...
