Smart and Stupid Arguments for Active Management
- Joshua M Brown
- June 2nd, 2013
It used to be I was surrounded by proponents of both passive and active management and the discussions in the office and at bars and coffee shops would rage on forever. These debates were evanescent with fresh facts, every twist and turn in the markets brought a renewed vigor to the back-and-forth.
But this conversation – as lively as it once was – has all but died in the last five years.
Passive investors have emerged so triumphant at this juncture that they barely even bother hurling their statistics at the crumbled walls of Alphaville anymore. At this point, the passivistas are now arguing amongst themselves about what constitutes a truly passive investment strategy – they bicker over the legitimacy of fundamentally-weighted indexes like 16th century Papists and Protestants.
Active investors, in the meantime, really can’t say anything. There isn’t a single empirical datapoint backing up the idea that an investor is financially better off paying someone to pick their stocks for them. There are other considerations in favor of a active managers – mostly emotional ones involving elbow-rubbing, fancy lunches and alerts – but we’ll leave those aside for now.
Active mutual fund managers have been clinging to the collar of the bull market for half a decade now, barely keeping up in most cases, severely trailing in others. Hedge fund managers, in the aggregate, have accomplished little aside from wealth transference in this cycle – they were hammered in the crash and then made up for that by largely missing the rebound. In the meantime, the inbound equity fund flows are moving almost unidirectionally into the passive index coffers of Vanguard, State Street, WisdomTree and BlackRock’s iShares. The modern investing decision has become one of degrees of passivity and the outflows from the Fidelity Funds of the world bear this out.
It’s not as though the pro-active management contingent has thrown in the towel, however, it’s just that they’re a lot less vocal these days. Like Marlins fans, they keep their heads down and their mouths shut. Che Guevara said that “Silence is argument carried out by other means,” and I think we’re seeing just that right now.
To be sure, there are some logical arguments to be made on behalf of active strategies – some make perfect sense and some are ridiculous.
Marketocracy’s Ken Kam, who has spent a career studying and vetting active managers, touches on one of each type in an interview with Covestor the other day.
First, his smart argument, the thing about all strategies that is always true:
My experience has taught me two important lessons. One, there is no sector or investment style that works all the time. And two: a great manager gets that way by honing his skill in a single sector or style. The combination of these two lessons is that if you want good performance over time, you can’t get it by using the same managers year after year.
My approach is to look among the managers who have proven themselves over the long term to find those whose style is performing well now. If there are a lot of proven managers who are all performing well now, then I choose managers whose styles are different from one another, to reduce the impact of any single manager’s style falling out of favor.
This is absolutely correct, there is no strategy – be it active, passive, value, growth, long-short, arbitrage, mean reversion, trend-following, stock picking etc – that will always work in all environments. Kam gets this correct. The trouble is, most passive guys say they don’t care about this or that style being out of favor, they will wait ’til the cycle swings back around – “Forget the needle, buy the haystack” Jack Bogle exhorts us. Most active guys, on the other hand, will be the last to recognize (or admit) that their expertise is not beneficial in a particular market moment.
Kam’s other argument is of the “stupid” variety. Please understand that this is a very smart man making it, so no insult intended:
Owning an index fund is like being a passenger on a jet on automatic pilot. Today’s automatic pilots are so good that one might argue that having a human pilot on board is an unnecessary expense. But would you be willing to fly on jet without a human pilot on board? Perhaps if the sky is clear you might consider it. But certainly not if you thought you might be flying into a storm.
I think index funds make sense for those who see clear skies ahead for the stock market. For those who see a storm coming, having a human pilot at the helm makes a lot more sense.
Okay, I’m gonna stop you right there.
The passive investor absolutely does not see “clear skies ahead” at all times. Rather, this investor recognizes that most managers will not be able to detect and react to the thunderclouds in a timely, consistent way. In addition, many of them will be so hyperactive that every gray cloud will appear to be a hurricane, and so a lot of buying and selling (churn) will be the result – leading to higher taxes, trading costs and potential for missed opportunities.
Also, about the jumbo jet thing – we used to use a variation of that f*cked-up, fear-mongering argument in the brokerage biz over the phone back in the day. When a prospective client would remind the broker who was pitching him that they had never met in person, the broker would reply, “Jim, let me ask you a question – the last time you took your family on a plane flight, did you meet the captain and his number two in the cockpit? Did you ask them to take a breathalyzer before you took your seats in the cabin?” It was one of those snarky rhetorical questions built into the sales pitch to accomplish two things: Make the guy feel stupid for bringing that lack of familiarity up and to inject a bit of healthy fear into the already emotionally super-charged discussion, hence making a close seem almost like a relief to the prospect.
Whether or not you choose to be passively or actively invested in the market does not at all carry with it the same gravitas as the decision to fly through a storm on a particular type of aircraft. Gain vs Loss is not the same as Life vs Death and the implication of that analogy is grotesque.
Let me just close here by saying that I am an agnostic on the argument. I believe that active management has a place in a portfolio, specifically as it relates to asset allocation and course correction. I also believe that some people and firms can be really good at selecting securities and timing markets – but there are less of these people than you think and even they can only outperform for a finite period of time before mean reversion catches up. If you haven’t read Mauboussin’s The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing I would ask that you please do so before arguing with me, the math is the math.
But I do believe that most people are better off doing as little as possible and that hunting for the next Tesla or Google should be firmly classified as a form of entertainment, cordoned off from serious retirement assets and unrelated to the future income one is counting on. Whether or not we are successful in identifying the next ten-bagger stock should not determine whether or not we spend retirement driving a golf cart or pushing a shopping cart.
There’s nothing wrong with deriving a bit of our entertainment from the markets each day as opposed to just pro sports or movies. So long as we keep in mind that, as Bernard Baruch instructs us in the first of his Ten Rules, speculation on a meaningful scale should only be carried out by professional speculators.
The problems with being completely orthodox passive are well-known and just as legitimate – indices tend to overweight the most overvalued stocks just as they are peaking out in both market capitalization and importance, by owning losers along with winners you are saying all companies are worthwhile holdings which is obviously false, indexes will never get out of the way of index crashes – obviously, and in flat markets (think the aught’s decade) you are basically sitting back and accepting mediocrity.
My own belief system, which continues to evolve as new information presents itself because I am an investor and not a politician, says that less is more. It also says passive is superior to active most of the time, but a little of the latter can go a long way if applied systematically and repeat-ably. This is easier said than done for most investors, specifically amateurs or part-timers, so it is better to err on the side of doing too little rather than doing too much.
Unfortunately I can’t join either church completely, but you can probably tell which one I am facing when I pray each quarter.
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The Reformed Broker is a blog about financial markets and the economy. Joshua Brown is a New York City-based investment advisor for high net worth individuals, charitable foundations, retirement plans and corporations... More.