Back in June, I noted that Wall Street has ridiculed passive investing for decades. The attacks began almost from the moment John Bogle started the First Index Investment Trust (later renamed the Vanguard 500 Index Fund) on Dec. 31, 1975.
At the time, competitors heavily derided it, even calling it “un-American” and “Bogle’s folly.” Now-retired Fidelity Investments Chairman Edward Johnson was quoted as saying he couldn’t “believe that the great mass of investors are going to be satisfied with receiving just average returns.”
One of the many ironies is that Fidelity is now one of the leading providers of index funds. It also was the first fund family to offer a zero-expense-ratio index-based ETF.
My article went on to reveal the absurdity of certain claims made about passive investing. Yet even this type of exposure doesn’t seem to stop the perpetrators of such baseless assertions. After all, their profitability, and even their very survival, depends on investors believing that active investing is the winning strategy.
A July 2018 article on Seeking Alpha, “Passive Index Investing, A Bubble Bound To Burst?”, provides another opportunity to expose the false nature of claims made about passive investing. I’ll examine some of the assertions made by the author, beginning with: “Investors are euphoric about passive indexing, and it is becoming an overcrowded trade with low prospective returns over the next 5-10 years.”
Let’s begin by examining the claim that passive investing is becoming overcrowded. According to the Thomson Reuters Lipper second-quarter 2018 snapshot of U.S. mutual funds and exchange-traded products, active funds of all kinds, including money market funds, manage about $16.4 trillion. That’s more than 2 1/2 times the $6 trillion managed by passive funds and ETFs. If anything is overcrowded, it’s active management.
As explained in my book, “The Incredible Shrinking Alpha,” which I co-authored with Andrew Berkin, for decades now, academics have been busy converting what once were sources of alpha into beta through the publication of their findings.
For example, while there was a time that active managers could claim alpha by overweighting small-cap, value, momentum, quality, profitable and low-beta/low-volatility stocks, that is no longer true. The reason is investors today have access to those factors through low-cost, passively managed funds, such as index funds and ETFs.
In addition, the publication of information about anomalies, such as post-earnings announcement drift, which causes momentum in stocks with positive or negative earnings surprises, leads to their shrinkage, or even disappearance.
Yesterday’s Alpha Becomes Today’s Beta
The result is there are fewer sources of alpha. Yet according to the 2018 Investment Company Fact Book, at the end of 2017, there were more than 16,800 funds, the vast majority of which are actively managed. Compare that figure to the roughly 100 active funds there were 60 years ago. The supply of alpha is shrinking, while the number of funds trying to feed at the alpha trough has mushroomed. There just isn’t enough alpha to go around. Active management is overcrowded.
As to the author’s claim that overcrowding leaves passive investing with low prospective returns over the next five to 10 years, I refer you to William Sharpe’s “The Arithmetic of Active Management.”
In his famous paper, Sharpe noted that because the market consists of active and passive investors, and, in aggregate, passive investors earn the market return less low costs, in aggregate, active investors must earn the same market return less high costs. The result is that if passive investors are doomed to low returns over the next five to 10 years, it is due to the fact that valuations are high, not because of any overcrowding.
No Active Magic
Additionally, in aggregate, active investors also are “doomed” to those same low gross returns, but with even higher expenses.
The author continued with a discussion on the efficient markets hypothesis and claims that the superinvestors of Graham and Doddsville demonstrate the hypothesis is false.
While it is true there is a group of such investors all from the same ZIP code, and while the Buffett style of investing certainly generated alpha for a very long time, academic research has converted that alpha into beta. It uncovered factors that fully explain the excess returns of those superinvestors relative to the single-factor (market beta) CAPM, the three-factor (adding size and value) Fama-French model, or the four-factor (adding momentum) Carhart model.
Thus, the once-alpha for those superinvestors has now become beta when we include the newer quality and betting-against-beta factors. Many low-cost, passively managed funds provide access to these factors.
The author next discusses Andrew Lo’s adaptive markets hypothesis. Lo’s hypothesis, which I fully agree with, is that, while markets are highly efficient, they are becoming ever-more efficient as academics uncover sources of alpha and convert them to beta. Once that happens, as I’ve mentioned, passive funds can access them in much-lower-cost ways.
As good examples, the funds my firm used 20 years ago only accessed the beta, size and value factors. Today we now access the additional factors of momentum, quality/profitability, carry and what can be called defensive (such as low beta/low volatility). In addition, these funds all engage in patient, algorithmic trading strategies to minimize implementation costs.