Swedroe: New ‘Passive’ Criticism Fails

September 13, 2017

You can also see the failure of active management by looking at Morningstar performance rankings, adjusted for survivorship bias, for the 15-year period ending 2016.

The following table shows the rankings of small-cap funds from two of the leading providers of passive vehicles, Dimensional Fund Advisors (DFA) and Vanguard. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends DFA funds in constructing client portfolios.)



The average ranking of the two Vanguard funds is in the 26th percentile (meaning they outperformed 74% of all actively managed funds), and the average ranking of the three DFA funds is in the 9th percentile (they outperformed 91% of all actively managed funds).

Given that taxes are typically the greatest expense for taxable investors, in taxable accounts, the passive funds’ performance rankings would almost certainly be quite a bit stronger.

An all-too-accurate comment in the article comes from Alan Miller, founding partner and chief investment officer at London-based wealth manager SCM Direct, who stated: “The active asset-management industry is obviously under huge pressure because its performance has been disappointing for a long time. It’s trying to cling on, with a feeble excuse to justify its existence.”

Price Discovery Still Going Strong

Before concluding, I’ll address the oft-raised question of whether there are enough active investors working on what economists call “price discovery” to keep the markets efficiently priced.

Today there are more actively managed mutual funds, and more hedge funds, than individual stocks. In addition, active funds still control perhaps about two-thirds of investment dollars.

Active managers analyze stock valuations, and it’s their actions that set prices.

In other words, passive investors are investing in assets on which tens of thousands of active managers have offered their opinion regarding prices through their actions. That’s the wisdom of crowds at work.

The evidence shows this collective wisdom is very hard to beat. As my co-author Andrew Berkin and I show in our book, “The Incredible Shrinking Alpha,” today only about 2% of active managers are generating statistically significant alpha.

Clearly, we aren’t at the point where markets have become inefficient due to a lack of price discovery efforts. But that might lead one to ask: At what point will there not be sufficient managers analyzing stocks to ensure prices are the best estimate of the right price?

While I don’t think anyone knows the answer to that question, surely it’s far less than the tens of thousands of managers we have today. Perhaps even a few hundred would be enough.

In fact, it wasn’t until 1950 when the number of mutual funds topped 100. That number was still only at about 150 in 1960. And we didn’t seem to have any problems allocating capital and setting prices efficiently then. Today we have more than 9,000 mutual funds and probably more than 10,000 hedge funds. Do investors really need all those active managers to ensure capital is allocated efficiently? It doesn’t seem likely.

In summary, passive investing has been the winning strategy for decades, and will continue to be the winning strategy.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


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