Active vs. Passive: Why the Silliest Debate Rages On
CHICAGO -- The silliest debate on the planet continues.
The ongoing dispute over active vs. passive investing helped kick off the first day of Morningstar's annual conference here this week.
Apparently no one had read William Sharpe's paper the Arithmetic of Active Management. That arithmetic merely says that only half of the active investors can best the market as a whole before costs. Since nearly all money in stocks is either professionally managed or advised, after costs, active managers collectively must underperform.
So clearly Wednesday's debate took place on the shores of Lake Woebegone where 90% of managers can be above average. Looking out the window I saw Lake Michigan -- but obviously I was wrong.
Morningstar's Ben Johnson, who moderated the panel around this age-old debate, highlighted a number of headlines regarding the underperformance of active management and huge investor cash flows out of active toward passive index funds.
But panelist Rob Lovelace of American Funds claimed that some strong active managers are easy to identify and that most active funds outperform in down markets, saying "you get 100% of the downside in index investing." Yet he made no mention of the huge cash outflows from American funds that began after the 2008 stock market plunge, nor why the arithmetic didn't work in down markets in other words, how 90% could be above average in down markets.
Meanwhile, Diana Strandberg of Dodge and Cox Funds argued that active gives a chance for alpha and has less volatility when measured over longer periods. That lower volatility relative to performance is essentially alpha, as measured by the Sharpe ratio -- also completely illogical.
Vanguard's Joe Davis noted that the company has over $1 trillion in active funds. He said part of the fund inflows to index funds is due to the defined contribution plans adapting target date retirement funds, using passive indexing. According to Davis, the rise of indexing in U.S. equities is only in the third inning while global indexing is only in the first inning.
All four were critical of so called "Smart Beta" factor investing and agreed that low fees are important, whether using an active or passive strategy. To a degree, they also seemed to be in agreement that good active managers could be identified ahead of time.
CREATING THE FOG
Overall, there was far too much professional courtesy in the room and the panelists instead created fog around a subject that has crystal clear visibility. Had this panel taken place 15 years ago, I suspect the name Bill Miller, the former manager of the Legg Mason Value Trust fund would have come up early and often as proof successful active management can persist. And the final question might have been "is passive indexed investing dead?"
Still, I agree with the panelists that low costs, high tax-efficiency, and disciplined investing is more important than whether a strategy is active or passive.
When Johnson concluded by asking the panelists about the future of active investing, the cheerleading continued. There will always be a place for active and the death of active investing is grossly overstated, Davis answered. Strandberg claimed active investing will prove its worth going forward. According to Lovelace, active has been pushed to the edge in taking more risk, but active investing needs to focus on what it does best which is lowering volatility. As investing becomes more global, indexing based on where a company is domiciled becomes outdated, allowing active managers to cut through indexes for outperformance.
My only surprise around the active-passive debate over the past decade is that indexing is now about 37% of all U.S. equity funds. Investors are clearly grasping the arithmetic. This ranges from individual investors to huge pension plans like CalPers who are firing active managers in droves.
I suppose in that sense I'm glad this debate continues, as active investors are needed to keep markets efficient. That's key to the future success of indexing. So if I haven't convinced you of the silliness of this debate, I can live with that.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for The Wall Street Journal and AARP the Magazine, and has taught investing at three universities. Follow him on Twitter at @Dull_Investing.