Swedroe: Active Loser’s Game Also A Trap

September 01, 2017

The other day, one of my firm’s wealth advisors called me to relate his conversation with a prospective client who had questioned the academic basis of our evidence-based investment philosophy.

Specifically, she doubted the validity of the statement that most active managers persistently underperform their risk-adjusted benchmark. Her response was: “Of course they outperform, that’s what they get paid for. If they didn’t, no one would pay them.”

From her perspective, it might have seemed painfully obvious to believe this was the case. After all, investors are rational and would not pay for poor performance. Yet the evidence shows she could not have been more wrong.

In 1998, when Charles Ellis’s book, “Winning the Loser’s Game,” was first published, only about 20% of actively managed funds were generating statistically significant alphas. About 80% were not. That’s why Ellis called active management a loser’s game—a game that’s possible to win, but with odds so poor that it’s not prudent to try.

Thus, like all loser’s games (such as buying lottery tickets or playing slot machines), the surest way to win is to not play. With investing, that means using passively managed vehicles, such as index funds.

If the poor odds that Ellis describes aren’t convincing enough, as my co-author Andrew Berkin and I demonstrate in our book, “The Incredible Shrinking Alpha,” today the percentage of actively managed funds generating statistically significant alpha is less than 2%. We explain why this trend, in which active managers experience a persistently declining ability to generate alpha (that is, to outperform risk-adjusted benchmarks), is virtually certain to continue.

That, in turn, raises an interesting question: Why did this prospective client possess such a strong belief that active managers actually outperformed?

In Love With A Loser’s Game

One of the greatest frustrations for me, and one of the great anomalies in finance, is that, given the overwhelming amount of evidence against active management and in favor of passive investing, a majority of investors keep playing a loser’s game. I offer four explanations for this phenomenon.

First, the education system has totally failed the public. Unless they obtain an MBA in finance, it’s highly unlikely that investors have taken a single course in capital markets theory. Without the appropriate knowledge, how can investors determine whether an active or a passive strategy is the right one?

Unfortunately, many obtain their “knowledge” about investing from the very institutions—Wall Street and the financial media—that don’t have their interests at heart, because the winning strategy for them is when investors play the game of active investing.

Wall Street needs investors to trade frequently and to pay the high fees imposed by actively managed funds. The media needs investors to “tune in.” The result is that most investors are unaware of the historical evidence.


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