I received a question from a reader via email in which he asked me to address passive investing in a secular bear market. The reason for this is that he had been to numerous presentations recently which all seemed to tout “now” as being time for active managers to shine – “the return of active management” was how he described the message.
Canadian Capitalist just recently discussed the latest SPIVA Q4 Scorecard (which stands for Standard and Poor’s Index Versus Active scorecard) – the report indicated that active fund managers just barely managed to beat the S&P/TSX Composite Index in the fourth quarter of 2008 as a whole. Is there something to this?
Further, I’ve spoken to a number of advisors who paradoxically had recently been leaning towards indexation strategies only to now perceive active managers as being akin to kids in a candy store, that there are so many value opportunities that it should be easy-pickings and active management will deliver great returns going forward.
Wishful Thinking
First, let’s not forget how much money goes into marketing of active management. Actively managed mutual funds pull about $10 billion out of Canadians’ pockets every year if you assume an average cost of 2% on total mutual fund assets of about $500 billion (thanks to Michael James for pointing out my previously erroneous calculation of only $1 billion!). The industry knows what butters its bread – and they’ll spare little expense to convince investors and advisors of the merits of active management (in ANY market).
Second, according to a report I read recently (but the name and location of which escapes me at the moment) about 20% of the market is indexed. That means that 80% of the market is being actively managed in some way, shape or form. Active managers haven’t gone away, so there is no great “return” in the first place. If the best they can claim is that they don’t go down as much in a bear market (good) and don’t go up as much in a bull market (bad), then given that the market tends to go up twice as much as it goes down it’s not a very compelling argument, is it?
Third, 80% of the market is actively managed (yeah, same as the point above). So being able to outperform the market has the same hurdles as it ever did. Let’s pretend for a minute that there are no management fees for passive or active investors. Passive investors will get the market return no matter what because they hold the market. The rest of the investors (the active investors) in aggregate will get the market return too, since for every one who is overweight RIM, there must be someone underweight RIM, and so on for all the stocks in our universe. Some will beat the average, and some will lose to the average – but put them all together and they will get the market return too. So now, we re-introduce fees. Passive investors pay very little to blindly track an index, but active investors pay a lot. It’s a mathematical truth that a passive investor will beat the average active investor – and that holds true in bull markets, bear markets and everything in-between.
Another way to sum this up is to examine the statement “everyone being better than average” (and average represents the index). This can’t happen. The average is the average. And for passive investors the “average” costs less.
Finally, I’m not going to argue that all active managers simply cannot beat the average going forward, it’s just that there is no way to reliably identify these out-performers in advance… and I don’t care how many hours you spend on Morningstar or Globefund. :)
Thanks for the mention Preet. I’ve been under the assumption that active managers would be winners in down markets. After all, they hold a bit of cash and cash is king in a down market. But, apparently even in a bear market, the odds of outperformance with a fund isn’t very good.
“it’s just that there is no way to reliably identify these out-performers in advance”
Yes. It’s the ‘IN ADVANCE’ part that people just don’t get.
Plus, the fact that management fees must be paid makes it exceedingly difficult for an investor to choose a fund that beats indexing.
“Passive investors will get the market return no matter what because they hold the market. The rest of the investors (the active investors) in aggregate will get the market return too…”
This is actually a fallacy. It sounds like one of Zeno’s paradoxes.
It’s like saying that there are 6 investors. 1 indexes. 5 actively manage. 3 beat the market, 2 underperform. You’re suggesting that NECESSARILY the aggregate of the 5 actively managed funds will still be the market average. But that’s not true at all.
@ rm – I’m assuming (perhaps erroneously?) that “aggregate” is equivalent to “dollar-weighted returns” in which case I believe it is necessarily true.
In fact, once you consider extra transaction costs, higher turnover and therefore more tax then the active investors do even worse.
To take it a step further index trackers are more likely to engage in securities lending to the active investors who may occasionally short stocks – in which case the indexers are charging interest to the active investors who on a whole just use shorting to make side bets on the market as a whole – therefore the picture is even dimmer for the dollar-weighted active return.
Preet, great post. I’ve probably heard these auguments 100 times in the active vs passive debate. You’ve summarized everything to a t.
It’s funny that advisors (who expect money managers to do well picking undervalued stocks) would be optimistic about active management right now. Expensive mutual funds underperform the index by the widest margin during strong markets. This is mainly because of their cash holdings that drag down their performance most when stocks rise the most.
I suspect the real reason that advisors would be happy is that they expect good stock performance which will made investors happy. Most investors are happy to get a 10% return even if the index goes up 15%. So, during good times it’s much easier to hide 2% or 3% fees and leave investors happy.
I think you require investing to be zero-sum, but it’s not? Right? Dividends and such make it possible for it to not be zero-sum.
rm: Investing isn’t zero-sum, but trading is. If we start by assigning everyone the market average and then measure the difference between that and their actual results, the difference can be explained by fees and trading. Collectively, fees and trading are a zero-sum game.
Now that I understand “secular bear market” (thanks to your recent post) I’m a little confused. In a secular bear market won’t index funds lose by definition since they reflect the market and the market is on a long-term net downslide? In fact the only way to beat the market would be to actively manage (ie.g ?
If ETFs classify as passive investing then some of them could gain in a secular bear market.
Am I missing something here?
Investment Club,
That’s exactly what happened during the 1968-1982 secular bear market – where market returns were flat for the period – and from 2000 to 2009. You would have no real positive returns holding the S&P 500 during either of those periods.
Whereas there were many active managers who did extremely well through tactical re-balancing and strong security selection.
Not making money during this period as a passive investor assumes you don’t have a diversified portfolio and are concentrated in one or a few indexes.
There is an argument you can create a alpha using passive products through smart asset allocation. Question is what type of asset allocation outperforms secular bear markets? How often does it need to be rebalanced?
Perhaps graphs of a secular bear and secular bull market would make it easier for readers to see the difference in the two. After all, a picture is worth a thousand words as the old saying goes.
“The return of active management” sounds like a good way to convince people – it shows that the real skill in the funds is marketing.
With 80% of equity investments being actively managed they are the index; they’re really trying to claim than the funds can outperform themselves.
It would be amusing to explain to someone who’s all for active management that it can only work if actively managed funds generally underperform the index frequently and by a large amount. Then tell them that by buying an index fund you get the average wisdom of all their brilliant managers while they pay the fees :)