The Wall Street Journal recently published a series of articles under the title “The Passivists.” Highlighting the merits of a passive investment approach, authors tackle topics such as the fruitless endeavor of trying to pick winning stocks to the “Do Nothing All Day” investment approach taken by Nevada’s $35 Billion pension fund. For each article we provide a synopsis as well as our own additional comments to build upon the great work highlighted in this series.
Author Spencer Jakab speaks to why passive investing is here to stay based on three main themes:
It comes as no surprise the strong rise of passive investing in recent years. Just based on performance alone, the evidence the investors are better off paying higher fees for “expert” active managers is pretty dismal. While we expect a handful of active managers to outperform in any given year, once we expand the view to 5 years or more, it starts to look more like a graveyard.
But can the passive investment movement last? Many pundits believe that there will be an eventual tipping point for passive investing as the more “lazy money” creates opportunities for active managers to exploit inefficiencies or mis-pricings in the marketplace. Mr. Jakab makes the argument against these sentiments.
A big concern for traditional index fund investors is how the fund purchases securities. Because they attempt to closely match a commercial benchmark, like the S&P 500, as much as possible, many index funds will end up buying the same security on the same date, potentially pushing prices up for that particular security. Active traders in the market are aware of this and will “front run” that particular security knowing that it is almost certain to increase once index providers make their trades. All of this activity can potentially create extra costs that end up being passed on to the individual index fund investors as they are essentially buying into securities at premium prices (lower expected return). Robert Arnott of Newport Beach based Research Affiliates believes, “the drag on returns could be half a percentage point or more a year.”
Although professionals like Mr. Arnott acknowledge some of the inherent problem with traditional indexing, “they agree that the benefits far outweigh the costs for now compared with active funds.” Further, there are certain fund providers, like Dimensional Fund Advisors, that understand this particular pitfall in traditional indexing and take a more flexible trading approach in their particular strategies. As co-founder of Dimensional, David Booth, explains their approach, “we think indexing is too mechanical. A little bit of judgment can make a difference.”
Another criticism of index funds revolves around the attitude of believing that prices are fairly valued at all times. As Burton Malkiel astutely points out, “the paradox is that you do need active management to make the market efficient.” In other words, passive investors rely on analysts and traders taking in information, analyzing that information, and incorporating that information into security prices. If everyone accepted the notion that prices are fairly valued at all times, then markets would actually become inefficient, lending itself for active managers to reap the benefits.
Although in theory this is quite true, we are currently miles away from this actually manifesting itself in the marketplace. According to Morningstar, “66% of mutual-fund and exchange-traded-fund assets are still actively invested.” Charles Ellis, one of the earliest proponents of index investing gives his opinion on what it would take to get to a more inefficient market. “I’m very confident that 60% isn’t enough or that 80% isn’t enough. 90% may be enough,” he says. In other words, the passive market share would have to double or even triple from its current levels before we could potentially have the discussion of whether markets are no longer efficient.
Warren Buffett presents a very interesting conundrum to the debate of passive vs. active investing. Here is a man who has made his career off of active investing. As the WSJ article points out, “a dollar invested with the Oracle of Omaha’s Berkshire Hathaway Inc. between 1965 and 2015 grew an eye-watering 136 times as much as one in the S&P 500, making him living proof of investment skill.”
On the flipside, Mr. Buffett advises the general public to not follow his lead and instead invest in index funds. In his 2014 letter to shareholders, he wrote that when he passes away he would like his inheritance invested in the following: 10% in short-term government bonds and 90% in a very low-cost S&P index fund.
Mr. Zakab goes on to acknowledge that, “he isn’t a mutual-fund manager, and many studies have shown that actual investing skill, while it probably exists in some small percentage of managers excess in excess of their fees, only can be identified with hindsight.” Further, we have shown in previous articles that Mr. Buffett’s own “investment skill” is highly suspect.
We agree with Mr. Zakab that although many active pundits like to take shots at the merits of passive investing, they have yet to produce a significant argument that would inspire us to guide investors in a different direction.
You can find the original article published in the Wall Street Journal here.
 Zweig, Jason. “The Active-Passive Powerhouse.” The Wall Street Journal. October 21, 2016.
 Tergesen, Anne & Jason Zweig. “The Dying Business of Picking Stocks.” The Wall Street Journal. October 17, 2016.
About the Authors
Tom Allen is an Accredited Investment Fiduciary (AIF®), Certified Cash Balance Consultant (CBC) and a Chartered Financial Analyst (CFA®) Level III Candidate. Tom received his Bachelor of Science in Management Science as well as his Bachelor of Art in Philosophy from the University of California, San Diego.
Mark Hebner - Founder, Index Fund Advisors, Inc.
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.