Tradeless Nirvana

Active vs. Passive: Is the Tipping Point Here?

Tradeless Nirvana

Back in 2007, John Bogle, the founder of The Vanguard Group and the  author of The Little Book of Common Sense Investing, The Only Way to Guarantee Your Fair Share of Stock Market Returns", wrote the following endorsement of Index Funds: The 12-Step Program for Active Investors:

"This is an incredibly handsome and wise book. We must be near a 'tipping point' of passive over active. Perhaps Hebner's book will mark the moment."

A recent article from CNBC, The Existential Angst of the Domestic Equity Diva, suggests that the tipping point may have indeed arrived. Although the author, Eric Rosenbaum, is somewhat sympathetic to the plight of active managers who have been consistently suffering from net withdrawals, he does not mince words when diagnosing their problems:

"Mutual funds used to worry about losing their star managers to hedge funds, like Jeff Vinik of the Fidelity Magellan Fund (now owner of the Tampa Bay Lightning). Now, they don't have time to worry about losing stars to hedge funds or even the owner's arena luxury box, but about the rise of exchange-traded funds, low-cost index funds, and the reams of data on the inability of the average active fund to beat the benchmark. The mutual fund market has come full circle from an era when active managers like Peter Lynch (Vinik's predecessor at Magellan) and Bill Miller walked on water to a world in which the general investor assumption is that an active manager can never beat the market."

Index Funds: The 12-Step Recovery Program for Active Investors (2013)

Author: Mark T. Hebner
Year Printed: 2013

Buy the Book from Amazon

Ironically, In May of 2013, Vinik announced the closure of his hedge fund, Vinik Asset Management, after losing 4.8% since the start of July 2012, compared with a 19% gain for the S&P 500. This announcement came on the heels of investors demanding to withdraw $1.5 billion from the $8 billion fund. The decline in the fund's value was attributed to a large bet on gold mining stocks, which were hit hard by gold's plunge in April 2013. In IFA's Step 6: Style Drifters, we wrote about Vinik's ill-fated decision to shift about 30% of Magellan from stocks to bonds and cash. Regarding Bill Miller, the Legg Mason Value Trust Fund that he managed until the end of 2011 now has $2.3 billion of assets vs. a high of $20 billion in 2007.

The overall industry statistical data has been quite bleak for active management. As Jason Kephart of InvestmentNews points out in a recent article, "John Bogle Has Already Won" (a title suggestive of a tipping point), over the past decade, $442 billion has flowed into funds that are in the lowest quartile of expenses (a space that is dominated by index funds to the tune of 85%), while $368 billion has flowed out of the higher cost funds, according to Morningstar. The word chosen by fund consultant Geoff Bobroff to describe this is "staggering."

Echoing IFA's Step 1: Active Investors, Morningstar's President of Investment Research Don Phillips remarked, "The first step for active managers is to admit they have a problem. They really need to get their act together." Of course, "getting their act together" has several possible interpretations. For us, the best possible outcome would be that active managers come to the realization that they are playing in a highly efficient market, and that it is very difficult for them to both cover their costs and beat their benchmarks. Eugene Fama and Ken French elegantly conveyed this point in their 2009 paper, "Luck vs. Skill in the Cross-Section of Mutual Fund Returns". Obviously, we will not be holding our breath while waiting for this to happen.