The Myth Of Purely Passive Investing

July 11, 2017

[This article appears in our August 2017 issue of ETF Report.]

“Welcome to Lake Wobegon, where all the women are strong, all the men are good-looking and all the children are above average.” For decades, Garrison Keillor introduced the news from Lake Wobegon on “A Prairie Home Companion” with those words. We all chuckle when we hear them, mostly because they ring so true. After all, have you ever met a parent who described their kids as “below average?”

This is, in the end, the ultimate reason active investing is never going to go the way of the dodo. I know this from personal experience—I used to run an active mutual fund back during the dot-com boom. I like to tell the joke that “I was an active manager, but I got better.”

The pull to at least try to outperform is real. We all know the math, of course. As a class, investor experience must equal the performance of the market-cap-weighted benchmark of a given investment universe minus expenses. It’s a message that index proponents have been preaching for decades, and it’s taken hold of the investor zeitgeist, resulting in a near-trillion-dollar shift from active to passive since the financial crisis.

It Lives!

But active management is alive and well, and will continue to be, because there’s a huge part of the population that has a hard time settling for average. On paper, we invest just for returns. In reality, we also invest for psychological reasons.

Buying a lottery ticket is always a poor financial decision, but then again, so is going on vacation or buying a novel. Investors make imperfect, and occasionally noneconomic, decisions all the time. It doesn’t make them wrong—except in the strictest mathematical sense.

More to the point, I don’t know a single investor who actually holds the market portfolio of all available securities. I know that I don’t. Instead, even the most passive investor makes decisions about, e.g., what percentage to have in stocks or bonds, how much international exposure to have and whether to include commodities and real estate.

 

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