The Active Voice is Alive and Well

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Recently, we have seen many articles such as this one stating that the passive vs. active debate is over not because passive won but because the indexing advocates have drowned out the proponents of active investing. While there may be times when we wish we had the power to do that (figuratively speaking, of course), we readily acknowledge that investors are best served by a full airing of the two sides of this ongoing debate. That the active voice is not dead yet was made apparent by the appearance of this article (“Money Matters: Five Reasons Index Investing is not Your Portfolio’s Holy Grail”) from the Independent Press of New Jersey and this article (“Good Market for Actively Managed Funds?”) from the Wall Street Journal. Ironically, the author of the Independent Press article called out the Wall Street Journal for having complicity in conveying “the general sentiment that it is impossible to beat the market, so just throw in the towel and load your portfolio up with index funds.”

The one index that the author singles out for criticism is the S&P 500 Index. She claims that because it is weighted by market capitalization, the S&P 500 is much less diversified than is commonly thought. For example, 5% of the companies comprise 32% of the value of the index. This lopsidedness simply reflects the nature of the market itself where a relatively few large cap companies account for most of the capitalization. The S&P 500 Index, while only having about 14% of the publicly traded equities, accounts for about 75% of the total U.S. equity market, according to this article from Morningstar. As far as we are concerned at Index Fund Advisors, the S&P 500 is just the beginning of indexing. A truly diversified portfolio would include a significant exposure to domestic small cap as well as some value stocks that may not be included in the S&P 500. Furthermore, a diversified passive portfolio would also have exposure to equities and REITs from international developed and emerging market countries.

The next criticism levied by the author against the S&P 500 Index is also the argument used by proponents of fundamental index funds against traditional market-cap weighted funds—that they overweight “overvalued” companies and underweight “undervalued” companies. The fallacy inherent in this argument was exposed by Professor Andre Perold of the Harvard Business School in this article. Here is a simple way to understand his argument: Suppose that I present you with two diamonds of equal weight. One of them has a price tag of $10,000, and the other is priced at $20,000. I also tell you that one of the diamonds is overpriced while the other is underpriced. Naturally, your first instinct would be to assume that the higher priced diamond is the overpriced one. However, unless you are a gemologist, chances are you truly have no basis for saying that the higher priced diamond is the overpriced one. The same goes for companies in the stock market. Like fundamental indexing, the investing style that the author recommends would result in a tilt towards small cap and value companies, which would yield a higher expected return than the S&P 500.

Moving on to the Wall Street Journal article, the author quotes Owen Murray, an investment adviser in Houston who claims, “The current stock-market environment favors so-called active fund managers, who pick individual stocks in an attempt to beat broad market indexes.” At this point, we have no other choice than to invoke Ronald Reagan from the memorable 1980 debate against Jimmy Carter—“There you go again!” It seems that no matter how many times we debunk the myth of the stock picker’s market, it just keeps coming back so here we go again. Regardless of the correlation among individual stock returns, one stock picker can only benefit at the expense of another stock picker. As a group, all the stock pickers together receive the return of the market and after accounting for their expenditures resulting from their stock picking activities (e.g., research and trading costs), their return is well below the overall return received by passive investors who also get the market return but at a much lower cost.1 The key variable that determines whether a truly good stock picker has a chance to shine is the dispersion among the cross section of individual stock returns and not the correlation among them. For example, among the companies of the S&P 500 Index, 178 of them had a return of 20% or higher in 2012. Thus, a truly skillful stock picker would have had plenty of stocks to choose from.  If there were any stock pickers that accomplished the feat of only picking the high-performing stocks, we have yet to hear about it, and we will not be holding our breath.

As we stated before, the next time you hear a CNBC talking head say, “It's a stock picker's market," you can be sure that you have learned nothing about the market but a great deal about the fool who said it. We expect that we will continue to see more articles like those two for the foreseeable future, and we will always be ready to respond to them.

Sharpe, William, "The Arithmetic of Active Management," The Financial Analysts' Journal, Vol. 47, No.1, January/February 1991. Pp. 7-9.