On August 19, 2004, all eyes were on Google going public at a valuation of $23 billion, only six years after its founding.
A couple of months earlier, an interesting process took place behind the scenes. Jonathan Rosenberg, SVP Product, realized that the public offering was about to spawn thousands of impetuous young millionaires, most of whom had very little knowledge about finance and wealth management.
Thus, he organized several internal events to educate their soon-to-be rich employees and help them make the right decisions when confronted with the many tempting advice and offers from the masters of Wall Street.
Given the resources and the corporate culture, they looked for the very best minds to share their discoveries and wisdom. They brought into the ring three legends in finance:
- William Sharpe, Nobel Laureate, Stanford University sage, known as the father of the Capital Allocation Pricing Model, one of the founding pillar of the modern portfolio theory,
- Burton Malkiel, Princeton economics professor, former dean of the Yale School of Management’s, now Chief Investment Officer at Wealthfront,
- John Bogle, founder of The Vanguard Group, which pioneered passive funds
What Do The Experts Say?
What did these three legends of finance say? Very straightforward advice: choose passive investment. Said differently: put your money into low-cost, diversified index funds and get back to the real business of life. To borrow William F. Sharpe’s words “you can’t beat the average; net of costs, the returns for the average active manager are going to be worse.”
To make their argument clearer let’s define what’s passive investment. It is investing your asset in funds (mostly mutual funds or ETFs, even if there are more exotic vehicles such as index futures, index options and indexed protected products) that replicate a market. The managers of these funds are not asked to do research, predict acceptance of future products or growth of market share. They are just asked to buy securities in the exact proportion of a specific index to mimic it. It is called “passive investment” or “indexed investing.”
Why Recommending Passive Investment?
Let’s think a bit about the performance of active and passive strategies.
In 2016, the S&P500, an American stock market index based on the market capitalizations of 500 largest US publicly traded companies, had a total return of 9.54%.
Before costs, what did each passive investor get? Exactly 9.54%. What about the active investors? One might have made 13.3%, another 2.1%, yet another -25%, and so on.
But what did the average actively managed funds invested in the S&P500 return before costs? The answer has to be exactly 9.54%.
Why? Because the passive part returned 9.54% and the total market returned 9.54%. So the active part had to return the same (it’s just a consequence of weighted average).
But before-cost returns is not what matters.
Active vs Passive, All costs Included (Fees, Commissions, Taxes)
What matters is what you really earn: returns after costs and after taxes. You won’t be surprised at that point: active management is much more expensive than passive management. Depending on the market replicated, the cost of managing an index fund should be somewhere between 0.15% and 0.50%. The former will have a cost of at least 1% (100 basis points) higher than those of passive managers in the same markets.
100 basis points may not seem like a lot. But as Sharpe explains: “the long-term advantage of stocks over putting your money in the bank is currently estimated by many to be 5 to 6%. If you give up 1% in extra costs, you have sacrificed 16 to 20% of your overall gain from investing in the stock market. Over the years this can make a dramatic difference in your wealth, standard of living in retirement, and so on.”
And the costs are not only fees. The very activity that these managers undertake adds to costs. Brokers have to eat too, and many active stock funds sell stocks within a couple of months after they buy them.
And this isn’t the end of the costs: these trades generate realized capital gains far more frequently than does passive management, leading to taxes that could otherwise be either deferred or, in some cases, avoided entirely.
The bottom line is simple arithmetic, factoring costs and taxes, the average actively managed fund underperform passively managed funds in a given market.
Can You Beat the Average?
At that step, you may concede (you’d better if you like to consider yourself mentally sane) that the average actively managed fund underperform passively managed funds.
But who said you would pick the average manager, or be average yourself?
Here comes the worst part. By and large, the empirical literature shows that after fees and expenses, most active equity funds underperform the market portfolio over long horizons (eg: Jenson (1968), Carhart (1997), Fama and French (2010), Busse et al (2014)). And this seems to be also true for bond funds (Blake et al (1993), Cici and Gibson (2012)).
In fact, one of the most recent BIS studies showed that after fees and expenses, the vast majority of equity funds have failed to outperform the market benchmark in recent years, even without major unforeseeable events.
So not only the average active fund underperforms passively managed funds (pure logic), but most active funds underperform their benchmark net of fees in the long run.
What About the Elite Active Managers?
The only hope then is to see whether a small minority outperform their benchmark or not.
Well, once again, the data aren’t very compelling. The study from BIS shows that between 2011 and 2016, funds that outperformed their benchmark have not done so consistently:
For example, 35% of European equity funds outperformed during 2011–12, but only 8% outperformed over a time horizon of six years.
This is even in the US, where the percentages are around 24% for 2011–2012 and roughly 3% for 2011–2016. Only 3% and 8% are doing so consistently for a period as short as six years!
(For the most curious minds: the fact that active managers are doing worse in the US may be explained by two elements (1) the financial market is overall more efficient in the US, as Sharpe said “if a sector is really well researched and there are a lot of people trying to find mispriced securities, the chance of finding an active manager that can cover costs and provide a net alpha is much smaller than in an area which is under-researched and under-examined.”, (2) the costs of passive funds are even lower than in Europe).
Last year, a research from S&P Dow Jones Indices found even worse results: Between 2013 and 2016, out of the 1034 funds that cover all large-cap, only 19.73% outperformed the S&P 500 index. The following year 15.69% of those best funds outperformed the index. By the end of the third year, none were able to outperform the S&P500 on a consecutive basis. The data showed similar results for mid and small caps.
Why are so many active managers you may ask? As John Bogle once said, “It is amazing how difficult it is for a man to understand something when he is paid a small fortune not to understand it.” Also, research has heavily suffered from survivorship bias. For example, according to S&P Global, only 34.11% of large-cap mutual funds that existed 15 years ago are around today. Needless to say, the 65.89% of funds that didn’t survive were mediocre performers when they were merged or liquidated out of existence. So a simple ranking of 15-year returns, which by definition focuses only on the 34.11% of funds that survived, will paint a far too rosy picture.
No one, really?! Beware of empirical study.
Does it mean that no actively managed funds beat passive managed funds consistently net of fees?
Of course not. Some funds manage to do so for several decades. But very few. And, when you start to check the data, and control dividends and risk, even Berkshire Hathaway, the legend among the legends seems to show only a small overperformance.
But to be fair towards active managers, you should also beware of empirical studies showing you a too gloomy picture, for at least four reasons:
- empirical evidences depends a lot on the period selected, which beginnings and ends are almost always arbitrary (for instance, the last comparison between tracking the S&P500 (SPY) and Berkshire Hathaway happens during the 10-year period where SPY peaked, it is plausible that Berkshire will do significantly better than SPY including the following years in the time period). For instance, if you take the annualized performance until 2011 of the French CAC40, it can be up to 6% for the period starting in 2008 vs 0% for the period starting in 2000, and was also the case during the XXth, for instance if you compare the period after the second oil crisis (1979) which would lead to 6% of annualized performance vs the period starting after 1945 (data from LeBris, 2011, quoted by Sylvestre Frézal).
- past performance doesn’t predict future performance always correctly (otherwise it would be quite a simple exercise),
- even if statistically, using past data as a predictor, you may be better off favouring passive investment, it may not be the optimal decision for your specific situation (considering variables such as: time period, expected cash flows, taxation, funds selection, etc.),
- Corollary to the last point, it’s not only a question of beating the benchmark year after year, but it is also a question of magnitude and of when you cash in and cash out. If an active funds beat its benchmark by 20 points, then underperform by 3 points, you may cash out after year 1 or after year 2, you’d globally done better than passive investment (beware: market timing is not easy to do).
Should Everyone Become Indexed Investors?
Should everyone index everything? Definitely not. If everyone indexed, financial markets would cease to provide the (relatively) efficient pricing, since only research and active managers decisions keep prices closer to values, allowing eventually indexing to work. To be fair, we may find active funds fees and commissions too high, but index investing is a way to freeride, by leveraging their work without paying the costs. Thus there is a fragile equilibrium in which some investors choose to index some or all of their money, while the rest continue to search for mispriced securities. (Don’t be afraid, in 2017, the share of securities held by passive fund portfolios about 5% of the total in most markets and 15% in the US where it is the highest.)
Also, if you are looking for above-than-average performance, you need to play the game of active investment (be it you or someone else).
Should you index at least some of your portfolio? For William F. Sharpe, (Stanford, 2002), “this is up to you. I only suggest that you consider the option. In the long run, this boring approach can give you more time for more interesting activities such as music, art, literature, sports, and so on. And it very well may leave you with more money as well.”
My Personal Case
After discovering all these elements, I’ve checked my small portfolio of securities, put in life insurance under discretionary management in an online bank.
The data speaks for itself:
- the costs of the discretionary management are 0.85% (fees and brokerage)
- the average funds’ fees where my money was put were slightly above 2% (with often 100 basis points of retro-commission for my bank)
If you take the [5–6]% annual expected return mentioned by Sharpe, it means that roughly 50 to 60% of my expected gains before tax were taken by fees and commissions.
You can guess what my reaction was when I reread William F. Sharpe’s words: “You can’t afford to pay 3% of your money every year for advice, no matter how good it is.”
Some Actionable Insights
If you chose passive investment, you should have in mind these key elements:
- It’s not an all-or-nothing decision; you may choose indexed investing for only a portion of your asset.
- The main parameters of ETFs you should look for are: (a) Underlying Index or Asset, (b) expense ratio (the lower the better), (c)the level of assets (>$10m, the higher the better), (d)tracking difference (the lower the better) , (e) the trading activity (the higher the better), (f) tax efficiency (the lower the short-term cap gain the better).
- Passive investment requires some decisions as well since you need to select ETFs or mutual funds to invest in. There are famous “lazy portfolios” that you can copy with associated ETFs, also called 1/N portfolios given the split is done solely on the existence of N asset classes…
- 1/N portfolios are designed to have some type of diversification, such as:
- asset class (bonds, equity, cash equivalents, commodity, real estate…),
- types of underlying assets within an asset class (eg: small cap, mid cap, large cap)
- geography (US, Europe, emerging market…)
- some combination of the former.
- Selecting ETFs implies understanding the basics of expected return and risk. Expected return is related to the expected return of the securities, but risk is more complicated. Risk is related to the risks of the individual components as well as the correlation.
- Markowitz, the other father of the modern portfolio theory, showed that you should not just have a compartmentalized approach (adding randomly some ETFs). You should take into account covariance: the correlation between assets and the magnitude of variability in the returns of each asset. You want to think about how things move together and diversify accordingly.
- There are softwares that assess the optimality of your portfolio, by identifying the subset of efficient portfolios that offer the highest expected returns for different level of risk (the “efficient frontier“ in Markowitz jargon), and then figuring the specific portfolio you should favour within that efficient frontier, given your objectives and risk aversion (Blackrock call it Aladdin, for instance).
- Optimized portfolio (using the Markowitz approach) usually outperform equally weighted portfolios (1/N Portfolios).
- Building an optimized portfolio is not a one-off decision since price changes will cause the actual asset mix of your portfolio to drift away from its initial weights, rendering it suboptimal. For any multi-asset portfolio, you need indeed to do portfolio rebalancing, which to be done properly needs to take into consideration not only the asset class weights and their distance from your optimal balance but also the costs of rebalancing (you need to compare the cost of rebalancing cost (mostly brokerage fees and taxes) and the cost of suboptimality to decide when to rebalance).
For the average Joe, one good option to build and manage a portfolio is probably to opt for robot-advisors, such as Wealthfront or Betterment in the US, which can optimize asset allocation, while investing in low-cost ETFs, which seems to bring the best of the worlds (low cost, no need to do the optimization work yourself). In France some of the most visible robot-advisors are Yomoni, WeSave, Marie Quantier, Advize and Nalo.
- One of the interesting takeaway of Markowitz efficient frontier is that while it is suboptimal to have a 100% bond portfolio (you could have a lower risk for the given expected return), but it is not suboptimal to hold a 100% equity portfolio in the long run (but that would imply having a very low-risk aversion), which does not require the work of asset allocation and rebalancing. This would be very close to the portfolio advised by Warren Buffet to his heirs in Berkshire Hathaway 2013 shareholder letter (which is probably also on the efficient frontier, with an expected return a bit lower but also a bigger downside protection, given the lowered standard deviation of the mix): “Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.“ For non-American readers, who would follow this advice, beware of the currency risk (exchange rates tend to revert to the mean over the long term so you may be tempted not to hedge this risk for long term investment (you can find ETFs to invest in euros in the S&P with a currency hedge, like this one) , yet sometimes it doesn’t and the research is not unanimous, for instance, the British pound declined from USD 4.96 in 1850 to circa USD 1.30 in September 2016).
One Last Word Before the Fun
Don’t forget that money is much more than a way to get more of it. Money is a means to be safe, to get peace of mind, to get more time (by buying goods and services instead of doing all by yourself), but it is also a catalyst for action and a lever to transform society in a way you wish it becomes.
So your objective may not be to maximize your expected return (by designing the proper portfolio allocation for your specific aims, risk tolerance, and timeframe) but also to make your money work for a given cause (the stock price of a company impacts the managers’ and employees’ remuneration and the credibility of the company towards its business and financial partners).
Oh and by the way, let’s highlight that we framed the initial question narrowly: active vs passive investment in the stock market.
But financial markets don’t offer all types of assets, and all assets are not born equal. You can have a significant edge when you invest in real estate or private companies. And it may be an even better choice in terms of returns. But that’s for another article. And I might be a bit biased, being a VC.
It’s Quiz Time!!
In 2006, Warren Buffett posed a challenge. He bet $1m that the smartest hedge fund managers out there couldn't beat the world's simplest, most brainless investment over a ten-year period (01/01/2008-12/31/2017).
Warren chose to invest in an index of the S&P500. Protégé Partners, an advisory firm, took the bet. They selected the best 5 funds of funds*, that owned interest in more than 200 top hedge funds.
For podcast lovers, you can hear the story told by the amazing team of Planet Money.
* notice that none of the funds of funds beat the S&P500 net of fees for the total period.
Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
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Speech and interview of W.F. Shape at Stanford.
[Book] A Random Walk Down Wall Street, Buerton G. Malkiel
[Book] Extraordinary Popular Delusions and the Madness of Crowds Extraordinary Popular, Charles MacKay
[Book] Delusions and the Madness of Crowds, Charles Mackay
[Book] A Practitioner’s Guide to Asset Allocation, W. Kinlaw, M. P. Kritzman & D. Turkington
[Book] Common sense on mutual funds, John C. Bogle
[Book] The Elements of Investing: Easy Lessons for Every Investor, Burton G. Malkiel
[Book] The Four Pillars of Investing: Lessons for Building a Winning Portfolio, W. M. Bernstein [Book] Unconventional Success: A Fundamental Approach to Personal Investment, David Swensen