Swedroe: Passive Investing Misconceptions

September 05, 2017

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.

 

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