Illustration from Dante’s Inferno by Gustav Dore. Source: Wikipedia
In 1991 William Sharpe posited that active investment management would inevitably underperform passive management. He made two observations: 1). The returns on all active portfolios, in aggregate, would be equal to those of all passive portfolios; and 2). The higher fees that active managers charge would doom their portfolios, in aggregate, to underperformance.
Sharpe’s observations have been cited as if they were a geometric proof: irrefutable and self-evident. Luminaries such as Warren Buffett and Jack Bogle have used his “humble arithmetic” to enhance the image of passive management. And passive management has certainly grown in size and stature. It’s estimated that more than a third of all assets in the US are now in passive portfolios, up from a small fraction when Sharpe’s article first appeared.
But Sharpe’s argument rests on a flawed premise – that the market does not change, and that passive portfolios that own a small piece of every security. But we know that this is not the case. New stock is issued all the time; companies buy back their own shares; and other issuers go bankrupt and their shares are delisted. Sharpe’s hidden assumption is that the market exists ex nihilo, out of nothing. There are no additions or subtractions, one market, world without end, amen.
But passive investors still need to buy and sell. They need to trade to achieve their market cap weights. A favorite pastime of active small-cap investors is to estimate upcoming changes in the Russell 2000 index and front-run a stock’s inclusion or deletion from the index. One manager told me he can add up to 4% annually through such an approach.
Another issue passive investors face is when securities are issued or delisted. Passive investors must participate in every new issue, whether the new securities are overpriced or cheap. We see this a lot in the bond market. A company borrows just enough to insure that their bonds are included in a major index. Then they price their bonds aggressively and passive investors are forced to buy the debt to mirror their index, no matter how overpriced the bonds may be. When the bonds become free to trade, they “break” to a cheaper level, and passive investors lose out. Aggressive company management treats the market like a piggy bank – breaking in for spare cash whenever they want.
Passive investors need to actively trade their securities to keep up with market changes. Large cap indices may not turn over much, but small cap and bond indices do. Bonds mature, stock is issued, companies go out of business. Annual turnover in high-yield bonds can be close to 100%. When passive investors trade, informed active investors can profit from their activity.
Average yearly turnover in various indices. Source: CFA Institute
Both active and passive investment are needed. Passive management allows broad to access to capital markets at a low price. And active management is critical as well: by actively buying and selling shares, active investors send price signals to companies, raising or lowering their cost of capital. Investing isn’t a zero-sum game, it’s a positive-sum game. Investors gain from market-based returns; companies gain from access to capital. Both sides gain when the markets are deep and liquid, a function that both active and passive managers fill.
Active investing isn’t doomed. It has enduring, structural advantages that will always allow intelligent, informed investors to add value over time. And by helping to set prices and make markets more efficient, active investing serves a valuable economic function, which benefits everyone. More investing, please.
Douglas R. Tengdin, CFA