Swedroe: Passive Investing Misconceptions

Howard Marks is one of the financial industry’s most respected investment managers—for good reason. In 1995, he co-founded Oaktree Capital Management and built an enviable track record, with an emphasis on high-yield bonds, distressed debt, private equity and other nontraditional strategies.

His “memos” to Oaktree clients are the only ones of their kind I read (other than market analyses on which I’m asked to comment by our clients). I make it a point to read them because they are almost always filled with investment wisdom that every investor, whether active or passive, can put to work.

Key Insights

Marks’s latest, “There They Go Again … Again,” is no exception. Like many of his memos, this one contains cautionary tales, advising investors to not get caught up in fads. He warns investors:

• “The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology. 
• In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been.
• Asset prices are high across the board. Almost nothing can be bought below its intrinsic value, and there are few bargains. In general, the best we can do is look for things that are less overpriced than others.
• Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need.”

He then added the following points about U.S. equities:

• “The S&P 500 is selling at 25 times trailing-twelve-month earnings, compared to a long-term median of 15.
• The Shiller Cyclically Adjusted PE Ratio stands at almost 30 versus a historic median of 16. This multiple was exceeded only in 1929 and 2000—both clearly bubbles.
• While the “p” in p/e ratios is high today, the “e” has probably been inflated by cost cutting, stock buybacks, and merger and acquisition activity. Thus today’s reported valuations, while high, may actually be understated relative to underlying profits.
• The “Buffett Yardstick”—total U.S. stock market capitalization as a percentage of GDP—is immune to company-level accounting issues (although it isn’t perfect either). It hit a new all-time high last month of around 145, as opposed to a 1970-95 norm of about 60 and a 1995-2017 median of about 100.
• Finally, it can be argued that even the normal historic valuations aren’t merited, since economic growth may be slower in the coming years than it was in the post-World War II period when those norms were established.”

He also added a warning about “super-stocks” (FAANG: Facebook, Amazon, Apple, Netflix, Google) and warned that, while these are great companies, they are selling at historically high multiples and aren’t invulnerable to competition and change.

So far, so good. Investors should be aware that valuations are high. That means forward-looking return expectations are now much lower than historical returns. And just as once nifty-fifty, “sure-thing” stocks such as Polaroid, Eastman Kodak, Digital Equipment, Burroughs and Xerox have “gone with the wind,” the FAANGs could suffer similar fates. In other words, valuations matter, and investors should not be caught up in fads, or chase recent great returns.

Perspective On Passive

Marks then turned his thoughts to the trend toward passive investing. He writes: “Like all investment fashions, passive investing is being warmly embraced for its positives:

• Passive portfolios have outperformed active investing over the last decade or so.
• With passive investing you’re guaranteed not to underperform the index.
• Finally, the much lower fees and expenses on passive vehicles are certain to constitute a permanent advantage relative to active management.”

He then added: “Does that mean passive investing, index funds and ETFs are a no-lose proposition? Certainly not:

• While passive investors protect against the risk of underperforming, they also surrender the possibility of outperforming.
• The recent underperformance on the part of active investors may well prove to be cyclical rather than permanent.”

He continued with what he called “a few more things worth thinking about.”

Marks writes: “Remember, the wisdom of passive investing stems from the belief that the efforts of active investors cause assets to be fairly priced—that’s why there are no bargains to find. But what happens when the majority of equity investment comes to be managed passively? Then prices will be freer to diverge from ‘fair,’ and bargains (and over-pricings) should become more commonplace. This won’t assure success for active managers, but certainly it will satisfy a necessary condition for their efforts to be effective.”

He added this: “One of my clients, the chief investment officer of a pension fund, told me the treasurer had proposed dumping all active managers and putting the whole fund into index funds and ETFs. My response was simple: ask him how much of the fund he’s comfortable having in assets no one is analyzing.”

Then Mark noted: “Passive funds that emphasize stocks reflecting specific factors are called ‘smart-beta funds,’ but who can say the people setting their selection rules are any smarter than the active managers who are so disrespected these days? [Horizon Kinetics’ Steven] Bregman calls this ‘semantic investing,’ meaning stocks are chosen on the basis of labels, not quantitative analysis. There are no absolute standards for which stocks represent many of the characteristics listed above.”

A Rebuttal

Let me suggest another perspective on passive investing. I’ll begin by addressing Marks’ statement on passive investing not being a no-lose proposition and his supporting points.

First, as Marks correctly noted, passive investing certainly isn’t a no-lose proposition. But what passive investing does do is provide the opportunity to earn the return of the markets, asset classes or factors in which you are investing, less low costs.

While that means you give up the possibility of outperforming your benchmark, you’re also virtually certain to outperform the vast majority of active investors trying to beat the market. The only reason it’s not completely certain is that you would have to maintain the same type of discipline Warren Buffett has exhibited over the years—intelligence is the necessary condition for successful investing, but discipline is the sufficient condition.

The bottom line is this: You put the odds of meeting your financial goals greatly in your favor by accepting the returns the markets offer and giving up the hope of outperforming benchmarks.

Second, there is nothing cyclical about the underperformance of active managers. That’s a permanent condition, and has been so for a long time.

In his brilliant, and short, 1991 paper, “The Arithmetic of Active Management,” Nobel Prize-winner William Sharpe showed why this must be the case. And each and every year, the S&P Dow Jones Indices Versus Active (SPIVA) scorecards demonstrate that the majority—in most cases a very large majority—of active managers underperform their appropriate risk-adjusted benchmarks in every asset class.

For example, the 2016 SPIVA Institutional Scorecard, which covered the 10-year period ending in 2016, found that while active institutional funds produced better results than active mutual funds, across all asset classes within the domestic equity space, the overwhelming majority of active managers lagged their respective benchmarks. For example, the percentage of institutional funds underperforming their benchmark ranged from 63% (large value) to 96% (small growth).

The results in international markets were no better, with 81% of international institutional funds failing to provide value and 84% of mutual funds failing to do so. The performance was somewhat better in international small stocks, where “only” about two-thirds of active institutional and active mutual fund managers underperformed.

In the supposedly inefficient asset class of emerging markets, which has traditionally been thought to be one area where active management can add value, 79% of institutional managers fell short of the benchmark. Mutual funds performed even worse, with 86% of them underperforming.

And the results in bond markets were not encouraging either. In the 13 bond categories examined, mutual fund underperformance ranged from 59% (investment-grade bonds) to as high as 97% (high-yield bonds). For institutional managers, the results were similar.

Looking At Factors

I’ll now address Marks’s comments on investment factors, smart beta and the fund construction rules of passive vehicles.

First, I agree with Marks that a fund’s construction rules matter—a great deal. Furthermore, not all passively managed funds are created equal. Some have superior fund construction strategies.

That said, fund families such as DFA, AQR Capital Management and Bridgeway Capital Management, the three fund families my firm, Buckingham Strategic Wealth, uses to implement equity strategies, all base their fund construction rules on decades of academic, peer reviewed research.

This research shows which factors (traits or characteristics of stocks) demonstrate: persistence of a premium over long periods of time and across economic regimes; pervasiveness across the globe; robustness to various definitions; implementability (meaning they survive transactions costs); and have intuitive risk- or behavioral-based explanations giving us confidence that the premiums are likely to persist.

Once identified, specific portfolio construction rules are created and followed. And they also use patient-trading strategies to avoid some of the negatives of pure indexing.

Second, much of the academic research that has uncovered these factors (or what is often referred to as “smart beta”) can be viewed as reverse engineering. It identified the characteristics (such as low price-to-cash flow ratio, earnings, EBITDA or book value) that the most successful active managers have exploited. Once identified, other investors can access the same factors, though in a more highly diversified way.

This process effectively converts what was once alpha (a scarce resource) into beta (a common factor). And because beta is cheap to access, investors no longer need to pay the high fees of active management to benefit from exposure to stocks with these traits.

A good example of this process of converting alpha into beta is the 2012 study “Buffett’s Alpha,” authored by AQR researchers Andrea Frazzini, David Kabiller and Lasse Pedersen.

They found that, in addition to benefiting from the use of cheap leverage provided by Berkshire Hathaway’s insurance operations, Warren Buffett bought stocks that are safe, cheap, high-quality and large.

The most interesting finding in the study was that stocks with these characteristics tend to perform well in general, not just the stocks with these characteristics that Buffett buys. Thus, the quality factor was “born.” And now many passive funds incorporate it into their fund construction rules.

When Analysis Doesn’t Help Performance

Let’s turn now to Marks’ query about investing in a fund in which no one is analyzing anything. Let me offer a very different perspective on the question. Today we have more actively managed mutual funds, and more hedge funds, than we have individual stocks. Active funds still control perhaps two-thirds of investment dollars. These active managers analyze the valuations of stocks. It’s their actions that are setting prices. If they think a stock is overvalued, they will either avoid it or sell the stock short.

In other words, passive investors aren’t investing in something no one is analyzing. Instead, they are investing in assets on which tens of thousands of active managers have offered their opinions through their actions. That’s the wisdom of crowds at work.

The evidence shows that such wisdom—the wisdom of the market’s collective opinion—is very hard to beat.

As my co-author Andrew Berkin and I showed in our book, “The Incredible Shrinking Alpha,” today only about 2% of active managers are generating statistically significant alpha. I would add that active managers have performed just as poorly in bear markets as they have in bull markets. In other words, while passive funds go down in bear markets, the average active fund goes down even more.

Given the trend toward passive management, one might ask: At what point will there not be sufficient managers analyzing stocks to ensure that prices are the best estimate of the right price?

While I don’t think anyone knows that answer, surely it’s far less than the tens of thousands 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.

Markets Are Pretty Efficient

There is one other point to make. At least as of today, the fact that companies that report better- or worse-than-expected results still see higher volumes and larger same-day price moves implies there are still plenty of investors making the markets highly efficient.

As I noted, 50 years ago, there was a small fraction of the number of mutual funds we have today, and the hedge fund industry was in its infancy. On top of that, individuals dominated the market, because the majority of stocks were held directly by investors in brokerage accounts.

The research shows that retail money is “dumb”—active managers exploit its pricing errors. But even back then, the evidence was that on a risk-adjusted basis, in aggregate, mutual funds underperformed—though not anywhere close to as poorly as they are doing today.

For example, about 20 years ago, roughly 20% of active managers were generating statistically significant alpha. As noted above, the figure today is just 2%, with no evidence the trend is reversing. In fact, as Andrew Berkin and I explain in our book, the evidence suggests that, because the competition is getting ever tougher (more skilled), fewer and fewer active managers are able to outperform.

In summary, passive investing has been the winning strategy for decades, and it will continue to be the winning strategy. As William Sharpe showed, that’s simple math.

That said, investors should be aware of the concerns Marks has raised and ensure that their portfolio is highly diversified across many different unique sources of risk and return. Investors should avoid concentrating all of their risk in U.S. equities (due to a home-country bias), and also make sure all of their eggs aren’t in the single basket of market beta.

Diversifying across other unique factors and investments (such as reinsurance) that also meet all the criteria I listed (persistent, pervasive, robust, implementable and intuitive) creates a more efficient portfolio, and one with less volatility. You can see the benefits of doing so in both “Your Complete Guide to Factor-Based Investing” and “Reducing the Risk of Black Swans.”

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