If you have read my 2012 essay on “The Myth of Passive Investing” then you probably don’t need or want to read what’s below.
If there’s a consistent theme on this website it’s that I am trying to establish a consistent taxonomy and set of understandings of financial concepts so that people can better navigate the monetary world we live in. Sadly, finance and economics is filled with words that are used in such a general manner that they have virtually no meaning. For instance, the word “money” means a million different things to different economists. The word “investment” has no relevant meaning in the context of how most people use the term. Or the word “debt” which is almost never discussed in accordance with its corresponding twin sister, “assets”. Or the term “passive investing”, which is actually a combination of two words that have virtually no meaning in the context they are generally used….
In this Q&A I want to (again) touch on the last term, passive investing because I think our industry has a long way to go before this confusion goes away. This terminology is a serious problem since it allows funds to market themselves as something they are not. This is especially bad for the average retail investor who already wastes billions of dollars a year in fees and is more likely to waste even more as this confusion leaves the door open for misleading sales tactics. Further, at a higher level it leads to an inconsistent macro framework for understanding the world, confuses how assets are priced and misleads as to how involved we should be in “managing” our financial system. This debate has wide ranging and important ramifications for both the future of our politics and the future of financial management.
This edition of “Yeah, passive investing isn’t a real thing” comes to us courtesy of Howard Marks and his latest quarterly letter. I love Howard Marks and his missives, but I think this one missed the mark. Marks is clearly not a big fan of indexing and what he calls passive investing. We see this a lot from more active high fee managers, but we don’t usually see it from people of Marks’ caliber. So let’s explore some of his comments and his questions specifically.
Question # 1 – Is passive investing wise?
Before we can answer that question we need to first answer the question “what is passive investing?” Without clear definitions we cannot have a clear discussion. As I’ve explained before, this thing we call “passive investing” is an asset allocation strategy with low relative frictions that attempts to take the market return on a risk adjusted basis. But this begs the question “what is the market?” The market, in an aggregate sense, is the market of all outstanding financial assets. In other words, the only true benchmark in this discussion is the Global Financial Asset Portfolio. Anyone who deviates from that is essentially saying that that portfolio is wrong for some reason. In other words, you are making a discretionary decision to diverge from the one true market portfolio and that decision makes you an active investor.
Importantly, this debate is not about activity as these terms might imply. After all, a stock picker who buys and holds one stock forever can be even less active than an indexer. And indexing actually involves an enormous amount of underlying market making activity. Further, as ETFs grow in popularity the number of “indexes” is also expanding. We have an index for almost everything which further muddies the discussion.
So we have a terminological problem here from the beginning. Marks isn’t railing against “passive” investing because no one really invests passively (ie, we all deviate from the global market cap portfolio). He’s also not railing against indexing because indexing can cover very active strategies. So, my guess is that he’s railing against low cost indexing strategies that systematically buy/sell broadly diversified portfolios. Is that wise? Well, we know that most high fee managers underperform after taxes and fees. And we also know that diversification is the only free lunch in asset allocation. So the simple answer is, yes, it is generally wise to own low cost index funds as they diversify single entity risk in a tax and fee efficient manner.
But the Marks essay goes deeper. He says:
“Is it a good idea to invest with absolutely no regard for company fundamentals, security prices or portfolio weightings? Certainly not. But passive investing dispenses with this concern by counting on active investors to perform those functions.“
This seems like a misunderstanding. After all, an indexing strategy does involve fundamental analysis. For instance, the general buy/sell rule for the S&P 500 is that the S&P Index Committee decides to buy companies with a market cap of $6.1B and sells companies that fall below that threshold. That’s a really simple fundamental rules based approach to indexing, but there are plenty of low cost indexing strategies that construct their benchmark indices based on broad fundamental analysis. Heck, there is even an entire group of index strategies referred to as “Fundamental Indexing”.
But another core understanding is that these index funds are implementing active decisions that are the other side of active decisions. In other words, when I buy the S&P 500 in a rules based strategy there is a market maker or trader who is taking the other side of that trade. Their analysis might be an opposite set of rules or decisions or it might be a market neutral position that simply helps make the market in my fundamental indexing strategy. So yes, active investors make a market for less active investors, but that does not mean the less active investor is making some mindless decision.
In this section Marks also touches on a favorite piñata of mine – the Efficient Market Hypothesis:
“The key lies in remembering why it is that the Efficient Market Hypothesis says active management can’t work, and thus why it expects everyone (good or bad luck aside) to just end up with a return that’s fair for the risk borne . . . no more and no less. I touched on this in “There They Go Again . . . Again,” which will be the source for the next three citations:
. . . the wisdom of passive investing stems from the belief that the efforts of active investors cause assets to be fairly priced – that’s why there are no bargains to find.”
The Efficient Market Hypothesis is misleading at best. Yes, the market is fairly good at setting prices, but that does not mean active discretion is misguided and it does not explain why it’s hard to beat the market. The reason it’s hard for most active managers to beat the market is because taxes and fees are a huge hurdle to consistently overcome. The reality is that discretionary intervention in the market is a necessity. We are all active investors to some degree and so the entire notion of passive markets is a misnomer. The EMH doesn’t prove what its proponents claim it proves.
This is getting a little long so maybe I’ll break it up into two parts. Stay tuned!