Pay passive funds peanuts, get monkeys

Christopher Joye

In The Australian Financial Review I wade into to the contentious "active versus passive" investing debate and argue that "buying a “passive” or “indexed” fund is lobotomised investing predicated on the beliefs that: the market is smarter than you are; investors are systematically rational; assets are always properly valued with prices moving in an unpredictable “random walk”; and, finally, that one has no ability to identify those “active” managers that do consistently beat benchmarks. (Yes, they exist.) The problem is that every single one of these assumptions has at various times and across different sectors proven to be wildly incorrect, save for the question on your relative intellectual quotient and/or financial markets expertise. For those that never want to engage in analysis and/or are convinced they possess fundamentally inferior faculties, passive strategies may certainly be preferable to an “active” approach. And let’s be frank: many folks fall into this category." Click on that link to read the column for free via Twitter or AFR subs can click on the direct link here. Excerpt enclosed:

"Yet let’s also bust the utterly misguided myth that passive investing is universally superior to active. By active we mean any strategy that seeks to deliver post-fee returns above those offered by a naïve market capitalisation weighted index, ideally in risk (or volatility) adjusted terms. So what are the problems with passive? First, there are many asset-classes that are demonstrably inefficient where prices deviate materially from fair value, or intrinsic worth, and in which the average active “asset-selector” will comfortably trump passive indices. Think opaque sectors like private equity, unlisted credit, and residential and commercial property. These domains share several important features that distinguish them from the price-efficient listed equities market: they are not traded on a transparent and low-cost exchange; public reporting on prices and volumes of all transactions is either non-existent (private equity, credit, commercial property), or delayed many months (residential property); and the participants that predominate are often non-professional investors, motivated by non-financial considerations (eg, owner-occupiers), and/or passive (eg, buy-and-hold) players, all of which furnish the active adversary with an edge. Second, the foundation assumptions upon which Eugene Fama’s heroically simplistic “efficient markets hypothesis” rests have been comprehensively invalidated in even the most “semi-strong-form” or price-accurate asset-classes. Time and time again collective investor behaviour has been subject to bouts of persistent irrationality precipitated by innumerable behavioural biases that make a sham of Fama’s idealised “homo economicus” (aka the always accurate and objective human calculator). This has led to massive mispricings or bubbles that have burst via savage and sudden 40 per cent plus draw-downs in global sharemarkets. Recall the 1987 crash that followed the leveraged buy-out boom; the 2001 “tech wreck” that succeeded the internet-enabled “productivity miracle” in the late 1990s; or the 2007 global financial crisis that emerged after we had convinced ourselves that house prices never fall? Go back further through history and you will find that the ever-fragile vagaries of the human condition, polarised by the extremes of fear and greed, reassert themselves via hyperbolic asset price booms and busts over and over again. Indeed, it requires the University of Chicago’s entirely irrational hubris to contend otherwise. (You can of course always fall back on the less elegant explanation that passive strategies suit because you have neither the time or the wit to pit yourself day-in-day-out against the collective might of the great unwashed.) Even the conservative Reserve Bank of Australia has concluded that the "efficient markets hypothesis...cannot explain some important and worrying features of asset market behaviour" with "financial market prices appear at times to be subject to substantial misalignments, which can persist for extended periods of time". A third fact is that in markets where the average active manager does underperform the index, you need not invest with him or her. There is a wealth of empirical evidence showing that dogs remain dogs and those with “hot hands” can consistently beat bourses over long periods. Consider the US quant hedge fund Renaissance Technologies, which has on average returned 40.6 per cent annually after fees since 1987 (more than 2.4 times Warren Buffett’s returns) with only one negative year since inception and one year in which its net return was less than 21 per cent. This is not explained by insane luck: Renaissance’s strategies are “systematic” positions implemented by computer algorithms exploiting non-random anomalies in pricing patterns that have been unearthed by years of rigorous research. The final inconvenient truth for passive promoters is that the more successful they become, and the more money that is indexed, the greater the probability they will fail to beat the average active alternative. This is because a passive strategy is completely price or valuation agnostic investing: it simply holds a basket of stocks that track the index—actually less than the index after fees—irrespective of whether those companies are cheap or expensive. As more capital is passively allocated there are, by definition, fewer active managers (in a relative sense) working to correct mispricings. The more passive a market is, the more inefficient the pricing process becomes, and hence the more likely it is that active investors will be able to identify and profit from valuation errors. The ascendancy of the price-ignorant passive crowd can only in the final analysis propagate its demise as active managers inevitably provide superior performance. Now this is not to say active guys are perfect..." Read for free via Twitter or use the direct AFR link.

About this contributor

Christopher Joye

Christopher Joye

Portfolio Manager, Coolabah Capital Investments

Christopher Joye is Co-Chief Investment Officer of Coolabah Capital Investments, which is a leading active credit manager that runs over $2.2 billion in short-term fixed-income strategies. He is also a Contributing Editor with The AFR.


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