Frustrated Stock Picker

One Place Where Passive Management Doesn't Rule: Bonds – From the Wall Street Journal

Frustrated Stock Picker

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.


Active management has long dominated the world’s overall investment philosophy. The belief that one can outperform the overall market has been touted among almost every major financial media outlet creating an allure that all investors can do better than average. Combining this allure with the marketing machine that is the active fund industry and all of a sudden you have a trillion dollar industry earning in excess of 1% per year, on average.

The problem with this story is that we all know that the vast majority cannot beat the average. That is mathematically impossible. Further, one we start to peel back the layers of the active fund industry’s magic tricks, we start to see a historical track record that is built on an illusion, not robust results.

Investors have started to catch on to what we consider is one of the biggest con games that is still in existence. You can make more money selling your advice than by following it when you are an active manager and many have done so on the backs of the hard earned savings of investors. Because of the recent trend of moving towards a more passive investment strategy, the active management community is looking for ways to pare their losses. One firm believes that investors can find a better solution by combining passive with active while this particular article from the Wall Street Journal is trying to sell the active proposition on fixed income.

In short, it is all a bunch of nonsense.

Basic Math

Let’s just start with some very basic math. In any market, there are the winners, the losers, and the average. The average represents the combination of the winners and losers. In any transaction where someone is buying a security and one person is selling a security, one will be a winner and one will be a loser depending on the future price movement of that particular security, whether it is a stock, bond, commodity, a piece of real estate, etc. Therefore, there cannot be a majority of active investors who beat the market. It is a false proposition to suggest that the vast majority of the population will beat the overall market because it is impossible to do so. Some will outperform, some will underperform, and some accept the average.

The Snake Oil

This particular article in the Wall Street Journal presents an argument for why active management works in the bond market. These include, “complex trading” (whatever that means) that gives managers more opportunity to “stand out.” They also mention a company’s ability to issue many different types of bonds versus that of stock, which makes it “easier for active bond managers to find underpriced bonds and other debt securities beat their benchmarks, than do so is in the relatively transparent, efficient U.S. stock market.”

Again, this is all a bunch of nonsense.

The Facts

The WSJ article even reports the inferiority of overall bond fund performance. According to the article, “roughly 37% of U.S. taxable bond mutual funds tracked by Morningstar have outperformed their benchmark over five years through August, compared with 16.5% of actively managed U.S. stock funds.”

In other words, bond fund managers have done better than their stock fund manager colleagues, but the vast majority (63%) are still losing.

According to the SPIVA Mid-Year 2016 report, the majority of active bond fund managers failed to outperform their respective benchmarks across 13 different asset classes. The cumulative result across all 1,239 funds analyzed was 78.69% failing to outperform their respective benchmarks. See chart below.


Conclusion

While the active management community is continually fighting for their profit margins, investors are slowly catching on to their game. Whether you are investing in stocks or bonds, active investing will not work for the vast majority of people. Professionals have a hard enough time beating the market and that is what they dedicate most of the time of their day to. As we always recommend to our clients and the public in general, a much more reliable solution is to buy, hold, and rebalance a globally diversified portfolio of index funds.

You can find the original article published in the Wall Street Journal here.

 


About the Authors

Tom Allen

Tom Allen

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

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.