Michael Maubboussin’s latest piece on passive investing is, predictably, awesome. Since this is one of the topics I’ve spent WAY too much time thinking about I wanted to expand on his thoughts and see if we can’t add some further clarification here because I still think this industry is making a bit of a mess out of this whole “active vs passive” thing.
First things first. Because I am excessively anal retentive and detail oriented I should note that the term “passive investing” is wrong to begin with. There is no such thing. 5+ years ago when I started saying this all the time I was blasted as a heretic, but this has since become a more widely accepted view. If you want to explore my thinking on this you can read it here. But for this piece I will use the term “passive” because everyone else uses it. Capiche?
Now, Maubboussin makes a whole bunch of great points in his piece, but since I am a huge jerk I am going to criticize the points I disagree with. After all, it’s through disagreement that we find the greatest clarity. So, for instance, one of the points he makes is this:
“The investors who are shifting from active to passive are less informed than those who stay. This is equivalent to the weak players leaving the poker table.”
But is this really true? Are passive investors dumb money quitting the game? I say no. I say they’re smart money who just refuses to be drawn into the “smart money” attempts to bluff them. Here’s my thinking.
Poker is an imperfect analogy for the financial markets because the financial markets derive their returns from the cash flows that underlying corporations pay out over time whereas poker players take from one another in a fixed pool of existing funds. But let’s go with that example and expand on it in a more realistic sense. So, let’s just say that stocks are like bonds. I know, some people don’t like it when I say that, but stocks are, for practical purposes, corporate liabilities, that, in the aggregate, pay a fairly fixed coupon over time. If corporations paid this coupon entirely in dividends then stocks would look a whole heckuvalot like bonds. So, let’s just say that the financial markets are made up of instruments that pay 5% on average each year. In our poker game, this would be the equivalent of getting 5% more chips at the end of the year by doing nothing. Now, we never know what that instrument is precisely worth because it has credit risk so it might actually pay 5% or it might not. So its price changes over the course of the year to account for that. Are we all on the same page still? I hope so.
Now, what the “passive” investor does is buy an aggregate that is essentially a high quality diversified instrument that will pay that 5% each year. They do this via the instrument that will reduce their taxable events and fees as much as possible. The more “active” investor, on the other hand, tries to time when the instrument is undervalued relative to the 5% payout. So, say for instance, that the economy goes into a tailspin then Joe Schmo might get scared out of his instrument and sell it at a discount assuming that the instrument won’t pay 5%. He sells at a discount and Billy Bob takes the other side of that trade. Assuming the coupon is stable over time, Joe is a dummy and Billy is a smarty because Joe will earn 0% in cash and Billy will earn his 5% coupon plus a premium.¹
Sounds easy, right? Well, not exactly. According to the annual SPIVA Scorecards this is an extremely difficult thing to try to do. But the kicker here is that 5% is the maximum aggregate payout. The underlying instruments are literally not designed to pay out more. So, the more active investor who incurs fees, MUST, by definition, earn less than the average investor who incurs less fees. That’s just Sharpe’s arithmetic of active investing.
So, now we have to ask ourselves – if the financial markets are a bit like poker then the passive investors are sitting at the table waiting for the bank to pay them their 5% in extra chips every year. They are not dumb money or weak money. They are simply patient money. And what they are refusing to do is engage in being bluffed into activity that MIGHT earn them 5.01% or more, but will DEFINITELY cost them taxes and fees. And yes, the more active investor needs to bluff the other players to engage in his attempts to capture any excess return. The alpha chaser in this activity needs “weak” hands, but the weak hands are not the passive investors holding their cards to their vest.² The weak hands are other more active investors engaging in the alpha chase who succumb to their emotional biases for whatever reason and buy/sell at inopportune times.
Ah, so who’s the dumb money here and who’s the smart money here? Is it dumb to hold your cards close to your vest and just wait for the bank to pay you every year while reducing your fees and taxes and not being greedy trying to churn out more return than the underlying instruments are capable of generating? Or is it smarter to wait for the behaviourally biased players to fold their hands and try to time whether you should take advantage of their weakness? There’s an argument to be made that both are engaging in a sort of smart game, but ON AVERAGE, the less active player is most certainly not dumb or weak. They are, arguably, more informed on average because they know that alpha is elusive in the aggregate and that engaging in this bluffing game is extremely difficult and that, after fees, will usually turn your portfolio into a losing portfolio.³
¹ – You’ll notice that Billy is not necessarily “smarter” or more informed than Joe. In most cases he’s just more disciplined.
² – I’ve played a good bit of poker in my life and I have to admit that I’ve never done it while wearing a vest so I can’t pretend to know what this actually means. Personally, I prefer to keep my cards on the table and sneakily look at the corners like you might see in the World Series of Poker. But I guess a fancy vest would be a nice way to look good while you lose money, which is usually what happens when I play poker.
³ – Most “active” investing these days falls in the category of market makers and arbitrageurs trying to capture fees and incremental inefficiencies in financial markets. While it is common to argue that active management is a losing endeavor these types of active investors perform incredibly well by serving the very necessary and useful role of middleman in the market pricing process.