In his previous column, Brad addressed questions related to the theoretical aspects of market efficiency and active manager performance. In this second of his three-column series on active vs. passive investing, he explores the challenges of implementing these strategies in the real world.

The previous column in this series focused on some theoretical aspects of market efficiency and offered points to help lead investors toward your passive corner. As they begin to march in this direction, however, other questions based on practical, if not emotional, considerations may arise. The following responses may reinforce their conclusion that a passive strategy provides the best odds of success.

Q: If there will be managers who beat the market, who cares if there are no more than would be expected by chance? We only need to pick one!

A: As explained in the previous column, equilibrium accounting presents a dilemma for active managers. We know that for every winner there must be a loser because active management is a zero sum game (before costs) relative to the market. This is due to the adding-up constraint, which infers that market returns must reflect all investors who collectively participate in the market. Therefore, the essence of the active-passive decision is to determine whether one can identify the active management winners in advance.

As I mentioned, there aren’t any more winners in this zero sum game than you would expect by chance, so the real issue is whether you can distinguish luck from skill among the past winners in an attempt to find managers who will win in the future.

There is a large volume of literature on this subject, and the conclusions generally point toward very little persistence in the superior returns of past winners. There may indeed be skillful managers, but the data is too noisy for us to pull them out of the sample that includes a large number who just got lucky. Your assumption should be that ex-ante, the expected alpha (or performance relative to the market return for a given level of risk) of any manager is negative, regardless of past performance.

Here’s another way to think about it. If you find a manager who was in the top quartile in the past, that manager has a 25% chance of being in the top quartile in the future. Unfortunately, so does every other manager, with the exception of those who charge extraordinarily high fees or have extremely high turnover, as research shows that high-cost and high-turnover managers are more likely to persistently underperform the market, net of fees and expenses.

Q: But I just read a report showing how the average manager outperformed in all the prior bear markets! Doesn’t that suggest the zero sum game did not apply in those periods?

A: These types of reports often suffer from two deficiencies. First, they usually fail to adjust for survivorship bias, which would impact the results dramatically. For example, the latest Standard & Poor’s Index versus Active (SPIVA) report indicates that survivorship in the most recent five-year period was 44.9% for Canadian equity funds.¹ If more than half the funds in Canada didn’t survive the last five years, imagine how small the sample of survivors would be today for the 1980-82 bear market. Drawing conclusions from such a small sample of survivors would be like attending a World War II fighter pilot convention and concluding that being a World War II fighter pilot results in longevity because everyone at the convention was over 80 years old. Unfortunately, that conclusion would not account for those who did not survive!

The other problem is the results in these types of reports are often equally weighted rather than asset weighted. Although it is generally instructive to show both, an equally weighted average does not reflect the actual outcome investors experienced. This is analogous to buying ten stocks but putting $91 in one stock and $1 in each of the other nine. An equally weighted return calculation would not fairly reflect the portfolio’s actual performance.

Q: Maybe in aggregate active managers won’t beat the market. But can’t they help protect me on the downside and smooth out the ride?

A: The zero sum game means it is mathematically impossible for active investors to collectively win in a down market, as the adding-up constraint holds regardless of the direction the market takes. As William F. Sharpe states in his article “The Arithmetic of Active Management,” “These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”²

It is no coincidence that passive strategies began to attract interest from US institutional investors in the summer of 1975. Many had suffered sharp losses in the 1973-74 bear market, despite employing active managers who claimed to offer capital preservation during difficult markets. The poor performance of actively managed strategies during the recent 2008-09 downturn provides additional evidence that, on average, active managers simply raise costs and do not provide superior performance in bear markets.

Q: An active manager incurs significantly higher costs for things like data sources, model development, research, and company visits. Don’t these added costs justify the higher fees associated with active management?

A: Higher fees cannot be justified because of the higher costs involved with active management unless you apply the logic Patrick Ewing used during the NBA work stoppage. In an interview following a collective bargaining session, he was asked to defend the escalation of player salaries to extraordinary levels, to which he responded, “People got to understand that we make a lot of money, but we spend a lot too!” The question is not are the costs of active management higher to the manager, but are the net benefits of active management higher to the investor? As we’ve discussed, the answer seems to be NO.

Q: ETFs and other passive strategies also charge fees. Wouldn’t these fees guarantee that an investor will underperform the market?

A: All investment strategies have costs, so the gross market return is not achievable for investors. Consequently, costs should be a factor when considering different passive strategies, and just because a strategy is passive doesn’t mean it is cost-effective. However, when you adjust for risk, the net return for the aggregate of all passive portfolios is higher than the net return for the aggregate of all active portfolios by roughly the difference in frictional costs. This is not a theory but a tautology, and it must hold every instant!

So, it is accurate to say that in aggregate passive strategies are guaranteed to underperform the market (even when adjusting for risk) by the amount of their frictional costs. But another way of looking at it is to say that the vast majority of active strategies will underperform by even more. Consequently, the odds are in your favour that the passive strategy beats the active one, even though it is guaranteed to underperform the market.

Q: Passive investing relies on the benefits of diversification. But does diversification even work anymore, given that everything seemed to go down in value at the same time, with passive strategies going along for the ride?

A: Although diversification neither assures a profit nor guarantees against loss in a declining market, it can help eliminate company specific (or unsystematic) risk in a portfolio. However, you cannot diversify away systematic risk, and this is what caused the market decline and drop in value of broadly diversified passive portfolios. Fortunately, systematic (or compensated) risk is the only form of risk you should expect to be rewarded for, and the only way to reduce it is to invest in a portfolio with lower expected returns.

However, contrary to what you may think, diversification has been more important than ever. Company-specific risk has increased significantly recently, and this is risk you can eliminate through diversification. It is also risk that you should not expect a reward for bearing!

When we diversify, we give up the opportunity to concentrate our portfolio in the best-performing investments in return for the assurance of avoiding overexposure to the worst-performing investments. Diversification continued to work during the most recent downturn. Although diversified equity portfolios experienced sizable declines, the losses in many widely held stocks were catastrophic—and in some cases irreversible. In addition, high-quality fixed income securities performed very well during the downturn, illustrating the important role of fixed income as a diversifier in balanced portfolios.

Q: Passive investing is a buy-and-hold approach, but does buy-and-hold really work considering investors didn’t make any money for the last decade if they just bought the whole US equity market and held it?

A: It is true that US equity investors have not been rewarded in the last ten years, but this is the risk you must accept as an equity investor in exchange for higher expected returns relative to less risky alternatives like US Treasury bills. If the risk never materialized, even over long horizons, it would be an arbitrage opportunity and the higher expected returns would not persist.

Investors shouldn’t be happy with the results over this period, but what is the alternative? If the alternative to a buy-and-hold approach is a trading strategy, the results likely would have been worse. Once again, the zero sum game’s adding-up constraint means that the only way to profit from your trading strategy is at someone else’s expense. You may get lucky, but chances are you will simply be adding more risk, higher transaction costs, and higher taxes to your portfolio while increasing uncertainty and broadening the range of possible negative outcomes in the future.

Moreover, if you’re contemplating pursuing stock picking as an alternative to buy-and-hold then you may want to consider Jim Davis’ recent analysis of all US stocks going back to 1926. He concluded that the best-performing stocks each year had a pronounced effect on the overall market return. The compound return on all US stocks from 1926-2008 was 9.4%. If you eliminate the top 10% of performers each year, the compound return drops to only 6%, and if you eliminate the top 25% of performers, your compound return goes down even further to an astonishing -1%.

Simply put, if you excluded the very best performing quartile of stocks each year, you would have lost money investing in equities over a period of more than eighty years! The implications of this finding are daunting for stock pickers, given that when you buy a stock—or continue to hold one you have already bought—there is a 75% chance each year that it will fall outside the universe of winners that accounts for all of the market’s return.

William Bernstein commented on Jim’s finding as follows.

“This may get you thinking: If a small list of securities accounts for the market’s long-term returns, why not avoid all the headaches and losses you’ve suffered recently by carefully choosing these super stocks? Simple: Because a portfolio of ‘carefully chosen’ equities could easily wind up with none of the best-performing stocks in the market—and thus produce flat or negative returns over many years . . . Remember that the point of investing isn’t to aim for the highest possible returns. It’s to make sure you don’t die poor. Yet trying to optimize your performance by seeking out the needles in the haystack is a sure way of becoming, well, poor.”³

Q: Aren’t passive strategies like ETFs best suited for do-it-yourself investors who don’t value expert advice?

A: The premise of passive investing is that no value can be added from stock picking or market timing. Passive investing doesn’t imply there is no value in expert advice. Most fee-based advisors focus on wealth management rather than stock picking or market timing. Wealth management is based on holistic advice revolving around things you can control, such as saving, spending, taxes, costs, risk management, risk budgeting, asset allocation, communication, and reinforcing discipline. The right passive investments fit very nicely in this framework, and the complexity of passive alternatives supports the need for professional advice.

Q: You make some good points, but I don’t fully grasp all of this and I’m not completely convinced. What is the bottom line?

A: Let’s say markets are in fact inefficient, that there are managers who do persist in outperforming, and that you don’t like the idea of indexing. The bottom line is that none of these points would really matter. Here’s why:

• If the market is inefficient, then the aggregate of all investors will still underperform a market rate of return by the amount of frictional costs (fees, trading costs, taxes, etc.). This is due to the adding-up constraint at work in equilibrium accounting.

• If there are superior managers, I have no way to identify them in advance and neither does anyone else.

• If you don’t like the idea of indexing, then let’s invest in passive funds that can address many of the flaws in merely tracking a conventional index.

The only question that matters is whether you, or someone you know, can reliably identify enough superior-performing investments, in advance and after costs, to outperform a market rate of return. The answer is probably NO! So let’s at least put the odds of success in your favor.

Investing is risky enough to begin with. Why add another layer of risk with no expected return?

For the first article in this series go to Active vs Passive: Man vs Market

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The comments of Sam Adams and Weston Wellington are gratefully acknowledged.

¹ Standard & Poors, Index versus Active Funds Scorecard for Canadian Funds, June 4, 2009, 5.

² William F. Sharpe, “The Arithmetic of Active Management,” Financial Analysts Journal 47, no. 1 (January/February 1991): 7-9.

³ William J. Bernstein, “Are Stocks a Loser’s Bet?” CNNMoney.com, May 9, 2009, http://money.cnn.com/2009/05/09/magazines/moneymag/stock-strategies.moneymag/index.htm (accessed July 15, 2009).

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