Swedroe: Passive Investing Misconceptions

September 05, 2017

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.


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