Acive v. Passive: The Most Appropriate Investment Vehicle for the Vast Majority of Investors

In this, the third installment of active v. passive investing we attempt to do a bit of a deeper dive and find out where Nobel Prize winning economists stand on this subject.

It was Nobel Prize winner - Professor Harry Markowitz - who first emphasized the importance of studying the risks and returns of an entire portfolio. Really the cornerstone of all of what we call Modern Portfolio Theory rests on this idea of diversification. And until Harry Markowitz gave what was essentially an engineering analysis of how stock price movements interacted with each other, nobody had ever really considered it. Even though prices don’t move in a smooth fashion, prices do go up and down over time. So a stock will go up and down, sometimes many times over the course of a day, but certainly over longer periods of time. And basically what he discovered was, that’s true and every stock does that, but they don’t do it at the same time, and it’s almost like if you think of two sine waves that are in opposite phase with each other, they ultimately cancel each other out. And even though it was not the case that these stocks were in opposite phase, as long as though they weren’t in exactly the same phase with each other, you still get some dampening effect.

Then, in the 1960s came another important breakthrough, when Professor William Sharpe (also A Nobel Winner) developed what he called the Capital Asset Pricing Model The CAPM, as it’s often referred to, is a model for determining the price of a capital asset such as a stock or a bond in an efficient market. The price, depends on two things - the risk of holding that security when markets fall and the expected return. Ideally, an investor should hold all the available securities within a particular market.

In the CAPM, Sharpe also introduced the concept of market beta - the measure of the volatility of a security, or portfolio, in comparison to the market as a whole.

Sharpe referred simply to market risk. But, in the decades that followed, fellow academics identified specific types of risk, or beta, often referred to as factors. This gave rise in the 1990s to the Fama-French Three-Factor Model.

Professor Ken French from Tuck School of Business says: “What we mean by factors are things that drive common variation across stocks. So if I’m trying to say, well, airline stocks tend to move together, you could imagine an airline stock factor because it’s going to pick up common variation. Or if you say, well, some stocks tend to move a lot when the market goes up, some stocks don't move so much when the market goes up. We can have a market factor in there that just picks up the difference in the way that stocks move relative to the market. We happen to know small stocks tend to move together and big stocks tend to move together. Put together a size factor, something the way we defined it, we had lots of small stocks and we’re short lots of big stocks that would pick up that variation between how small stocks behave and how big stocks behave. So there was the overall sensitivity to the stock market. We also knew small stocks had a higher premium than big stocks and small stocks tended to move together relative to big stocks. And then we also knew value stocks, companies whose ratio of book to market, earnings to price, or cash floated price - something where it was a fundamental of the company divided by the price. Those value stocks tend to have a higher average return than growth stocks.”

To the original three factors - market risk, size and value - French and Fama have since added two more, profitability and investment. So, companies with higher future earnings will have higher stock market returns. And, perhaps surprisingly, firms that increase capital investment tend to produce poorer subsequent performance than those that don’t.

Now some of that might sound a little complicated. But these are the basic building blocks of what is often referred to as the science of the capital markets. These are very important principles with implications for every investor. 

So, how can investors apply the academic evidence - the lessons learned from more than a hundred years of rigorous research? How can we apply that to achieving financial goals?

Most of all, the evidence should make us extremely wary of anyone who claims that they have the knowledge to beat the market. Because markets are fundamentally efficient, consistent outperformance is almost impossible. So, instead of paying large sums in fees to active fund managers to deliver average returns, we should invest instead in passive funds that simply track an index at a much lower cost.

Ultimately, though, it’s not about theories or intellectual arguments at all. It all boils down to simple mathematics.

Nobel Prize-winning economist William Sharpe says: “Think about all the securities in a marketplace and think about a strategy of investing proportionally, or broad indexing. If I have one percent of the money in that market, I’ll buy one percent of the stocks of every company in the market and I’ll buy one percent of the outstanding bonds. So I’ll have a portfolio that truly reflects the marketplace. Then think about all the people engaging in other strategies, active strategies, holding different amounts of this or that. Then you ask at the end of any period - What did the passive investors earn before costs? And let’s say that’s 10 percent, just to take a number. What did the active investors make before costs? It has to be the same number. So, before costs, the total market made 10 percent, the indexers made 10 percent and the active investors made 10 percent. After costs is a different story. A well-designed index fund should have a very low cost of management. It should also have very low turnover, very low transactions costs. Actively managed funds by their very nature have higher management fees, they employ more skilled people. They also have transaction costs because they’re active. So, after costs, the average passive investor must outperform the average active investor. That’s just arithmetic.”

The cost dispute, from an investment perspective, is counter-intuitive. If you think about your purchases in other areas of your life, if you’re out buying a car, you can buy a Porsche or a Mazda – and you’re going to feel a difference in the car. Whether it’s worth that price differential to you, only you as the buyer makes that decision. But you are definitely going to feel that there is a difference in quality in terms of power, styling, finish and so forth. In investing, that equation does not hold. When you think about yourself as a consumer (not an investor), we are used to ‘the more I pay, the higher the quality, or the better the results I get’. You come to investing and it’s just the opposite, and that is a really hard behavior for us to un-learn.

So, the fund industry won’t tell you this - it has far too much to lose by doing so - but by far the most appropriate investment vehicle for the vast majority of investors is the index fund.
Although it’s a relatively simple way to invest, requiring very little maintenance, there are still some very important decisions for index fund investors to make. Which I will elaborate on in the next post.

CBlakely CFP®, CTFA           12/2014

Source: YouTube video interviews of Professors William Sharpe, Kenneth French and Eugene Fama