Swedroe: Goldman’s O’Neill Comes Up Short

October 05, 2015

In a podcast interview posted last week, Tim O’Neill, global co-head of Goldman Sachs’ investment management division, warned investors that if passive investing gets too big, the market won't work.

He then added: "So in terms of the size, a market needs both active and passive investing, because if everybody’s a passive investor, there’s no one to buy from. And if passive becomes a certain oversized percentage of the market, the market doesn't function.”

O’Neill, who previously called passive investing “a potential bubble machine,” said that both strategies—active and passive—are necessary. But in the interview, O’Neill admitted: “It’s been a difficult seven years for active investors because the markets have risen so consistently and persistently higher. So most active managers have, net of fees, underperformed the benchmark.”

He went on to describe another “problem” with passive investing: “Of course, it’s all on autopilot. And when you get to periods of misvaluation, over or undervaluation, you need active decision-makers.”

Ulterior Motives?

Before we start unpacking O’Neill’s comments, it’s important to understand that he works for Goldman Sachs, a firm that needs and wants investors to buy into the game of active investing. Goldman Sachs and other Wall Street firms know the odds of active management outperforming its appropriate benchmarks are so low that it’s not in your interest even to play.

However, these firms need you to play so they (not you) can make money. And they earn it by charging high fees for active management that persistently delivers poor performance.

The financial media also wants and needs investors to play the game of active management. The more people they have “tuning in,” the more advertising dollars they stand to earn. When investors become hooked on investment noise (or what author Jane Bryant Quinn called “investment porn”), it produces profits for them. That’s one reason the financial media is filled with articles like the one that discussed the interview with O’Neill.

In short, the interests of the vast majority of the financial media unfortunately are not aligned with the best interests of investors. With that in mind, let’s address some of the points O’Neill made during his podcast.

What If Everyone Indexed?

We begin by considering the following statement: “If passive becomes a certain oversized percentage of the market, the market doesn’t function.” This is another version of the question: What if everyone indexed? (This topic is also addressed in detail in my book, “Wise Investing Made Simple.”)

It’s certainly true that if everyone indexed, society would lose the benefits that active managers provide. The price-discovery activities of active managers improve the accuracy of financial prices and allow for an efficient allocation of capital. Thus, passive investors don’t want everybody to become one. However, because we are so far away from that being a reality—for now and for the foreseeable future—it’s just a theoretical issue.

Today, perhaps 40 percent of institutional assets and just 15 percent of individual assets are invested in passive strategies. And while the trend toward passive investing is strong (and in my view, inexorable), perhaps about 1 percent of assets shift into passive strategies each year.

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