Recent Data on Passive Versus Active

One of the most important decisions an investor can make is whether to go passive or active. Passive accepts the market return, active seeks to beat the market return.

I am in the camp that says most investors investing for retirement should go passive (see previous post of "Proposal"). This rests on the belief that capital markets are mostly efficient. This means that stock and bond prices rapidly reflect publicly available information.

Believing in efficient markets practically comes with the territory of being an economist. Economists are drilled in the idea that when you have low barriers to entry, abnormal (i.e. greater than market ) profits won't persist. Take this idea to the capital markets where billions of dollars are on the line and it is pretty straightforward.

But this isn't an intuitive notion for most people. They hear their friend made a killing selling beanie babies and they run out and garner an inventory only to watch them gather dust later in their basement.

So what does recent data on passive versus active show? One of the most anticipated reports of the year  produced by Standard & Poor's is called the SPIVA report. This year, through 6/30/2016, 84.6% of large cap active managers underperformed the S&P 500 Index.

This means that if you bought SPY, the low cost index ETF, you outperformed 85 out of 100 managers for the year. For what it's worth, yearly performance is pretty much useless. Anything can happen in a year.

What is important is longer term performance because that is where costs that arise from active trading, management fees etc. come into play. The data shows that over the 5 years ended 6/30/2016 only 8% of active large cap managers performed better than the index. To break this down consider that if you had given 100 active large cap managers $1 million 5 years ago only 8 would have come back with better than index returns.

These results, along with the results of other market sectors, including "fixed income" are reported by Ryan Vlastelica in "How passive funds extended their dominance over actively managed rivals" /MarketWatch 9/15/2016.

There are various ways to try to beat the market. Some try to time the market, i.e. jump in when they think it is going up, jump out when then think it's going down. I call this the "hokey - pokey" approach to investing. And actually it amuses me. For example I was recently entertained by the mass exit called for after the Brexit vote. As we saw the market didn't fall off a cliff, instead it reached new records.

Another was to beat the market is to try and pick the best stocks. In this category I find especially interesting the so-called long/short Funds. If you think you can pick stocks then surely this proposition would interest you: study the stocks in the S&P 500 and short the 50 you dislike the most and with the proceeds buy equally weighted positions in the 50 you like the best.

Clearly, if you have any stock picking ability you would provide a superior return. Not only that but you should do well in any kind of market. This was, in fact, the pitch Funds following this approach presented. I know because I spent the first 20 years of my career investing for pension funds, endowments and other institutional investors. I heard the pitches.

How have they done you ask? William Baldwin, "Scary Results At Long-Short Equity Funds", 8/23/2016 Forbes provides some data. He says that Morningstar puts 133 publicly offered Funds in this category and that they returned 2%, average annualized return for 3 years ended 6/30/2016. The average stock index Fund returned 11.7%/year.

Is it really any wonder active funds are seeing huge outflows and index funds are seeing huge inflows. You don't need to be an economist to grasp that money flows from poorly performing high cost products to better performing low cost products.

My 2 Cents on Active versus Passive and Tony Robbin's "Money"

I'm working my way through Money, Master The Game by self-help guru and motivator supreme Tony Robbins.

One claim he continually makes is that passive management, using low-cost indexes, beats active managers who try to time the market and/or pick stocks, 96% of the time.

I think most people would agree that Tony Robbins is an exaggerator of the highest degree; and this, in my opinion, is an example of it.

Interestingly, there is no definitive percentage of active management underperformance.  When people throw out a number, they are basically referring to an average of numerous studies using various approaches.  Whether active managers can beat the market has been studied by academics, i.e. non-partisan researchers, for various time periods, various asset classes, and even for different countries.

My belief, from studying the results, is that passive wins 70% to 80% of the time over longer periods after all costs are taken into account.  If this is closer to the truth, then there are a fairly large number of managers and individuals beating the market by actively investing.  For every 1,000 investors in this category, 200 to 300 fall in this special group.

But, still the odds obviously favor the passive approach for most investors who are saving for their retirement.

I break it down to simple terms when I explain this to people trying to get to a successful retirement.  I say the active versus passive decision is like trying to draw a blue ball out of an urn that contains 200 to 300 blue balls and 700 to 800 red balls. Is this what most investors want to attempt when it comes to their nest egg?

Another point to understand, that Tony Robbins I think misses, is that many people who have underperformed just don't know it and actually believe they are doing well.  Consider that a simple 65% stocks/35% bonds portfolio more than quadrupled over the past 20 years.  For someone whose manager has tripled their assets over this period, he/she will likely feel they have done well.  In other words, they are clueless how much their manager has taken in fees and/or underperformed!  Probably they will go around touting their manager as a superior investment manager!

Keep in mind that there are always people who break the rules and win big.  In one of my favorite books, Rocket Boys, the memoir by Homer Hickam, the mother put every last cent in Johnson & Johnson stock because she saw all the kids in the neighborhood constantly needing bandaids etc. for their recurring scrapes.  She undoubtedly would look befuddled at the mention of diversification.  But her one stock approach bought her a nice place in Myrtle Beach!
 
A final point made in this ongoing debate is on the failure of superior performance to persist.  This means that picking the 200 to 300 market beaters over the last 10 years is futile.  What is generally missed, however, is that some percentage of the underperformers from the first 10 years will outperform by such an extent over the next 10 years that they will be superior performers over the 20 years!  Like zombies they come back!

Other than the irksome (to me) percentage, Tony Robbin's book is interesting albeit way too long and too much of a pump-it-up infomercial for my tastes.

How Did the Stock Pickers/Market Timers Do?

Standard & Poor's  tracks active fund manager performance relative to their index and calls this scorecard SPIVA (Standard & Poor's Indices Versus Active).  This is a comprehensive data set that strives to make apples-to-apples comparisons.  It studies consistency, takes account of survivorship bias, examines style drift, etc.

If you are interested in detailed information and trying to make up your mind on this important issue, you should spend some time reading the study.

Here are some broad results through the end of 2011:

ASSET CLASS	% of Actively Managed Funds That Beat Index Over Past 5 Years
U.S. Large Cap Growth Stocks	20
U.S. Small Cap Value Stocks	42
Int’l Stocks	22
High Grade Bond Fund s (Interm.-Term)	39
Intermediate Gov’t. Bond Funds	33

Source: Standard & Poor's

Sooooooo...if we step back just 5 years and get together 100 large-cap growth stock active managers, 20 are going to outperform.  Seems like we are in a "Dirty Harry" situation-

"Did he fire six shots or only five?"  Well, to tell you the truth, in all this excitement, I kind of lost track myself.  But being as this is a .44 Magnum, the most powerful handgun in the world, and would blow your head clean off, you've got to ask yourself one question:  Do I feel lucky?  Well, do ya, punk?