Swedroe: Recent Paper Swings & Misses

November 22, 2017

Passive investing has been ridiculed by Wall Street for decades. The reason is obvious. As American novelist Upton Sinclair wrote, “It is difficult to get a man to understand something when his salary depends on his not understanding it.”

The tidal wave that is the trend toward indexing—and passive investing in general—certainly has created what we could describe as an existential threat to the active management industry. That may explain why Wall Street has always railed against it.

As director of research at Buckingham Strategic Wealth and The BAM Alliance, I am often asked by clients and readers of my books and blog posts to comment on papers and articles extolling the benefits of active management and knocking passive management.

The articles are typically filled with statements that, at first blush, might appear to make sense, and they might even have a grain of truth attached to them; however, a deeper diver frequently exposes the “untruths.”

Indexing Bubble?

Most recently, I was asked to comment on an article titled “What They Don’t Tell You About Passive Investing.” It was produced by Morgan Stanley, and the thrust of the paper is that “the exodus from active to passive funds may be reaching bubble-like proportions, driven by an exaggerated critique of active management.” The author goes on to make various claims, of which we can examine the veracity.

For example, the paper states: “In the United States, historically, many active managers have tended to outperform in bear markets, but underperform in bull markets.” Certainly, that is true. But to me, it’s like a magician who is attempting to distract.

To begin, a fund or manager can underperform in bull markets and outperform in bear markets simply by owning low-beta/low-volatility stocks. And you don’t need active managers to do that for you. You also don’t need to pay their expensive fees.

For instance, you could invest in the iShares Edge MSCI Min Vol USA ETF (USMV), which has an expense ratio of just 0.15%. Investing in quality stocks can help achieve similar outcomes in both underperformance in bull markets and outperformance in bear markets. And you can use the iShares Edge MSCI USA Quality Factor ETF (QUAL) for that. It, too, has an expense ratio of just 0.15%.

Factor Exposure

In other words, if active managers outperformed in bear markets and underperformed in bull markets, that outcome likely was a result of their exposure to factors such as quality and low volatility, not any special skill they have as active managers.

A second distraction in the statement involves active management in bear markets specifically. It seems meant to lead you to conclude that, in general, active management outperforms in bear markets (it certainly does have the advantage of being able to move to cash). However, when we examine the evidence, we don’t see that to be the case.

For example, a study written up in the Spring/Summer 2009 issue of Vanguard Investment Perspectives defined a bear market as a loss of at least 10%, and examined the period 1970 through 2008.

The period included seven bear markets in the U.S. and six in Europe. Once adjusting for risk (exposure to different asset classes), Vanguard concluded that “whether an active manager is operating in a bear market, a bull market that precedes or follows it, or across longer-term market cycles, the combination of cost, security selection, and market-timing proves a difficult hurdle to overcome.”

The study’s authors “also confirmed that past success in overcoming this hurdle does not ensure future success.” Vanguard reached this conclusion despite the fact that the data contained survivorship bias, which favored active managers. Sleight of hand might work for magicians, but it doesn’t hold up to the cold, hard facts.


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