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Index versus active – our readers reprise

Last week’s article on index versus active portfolio management drew many comments, including on the website, by email and by forwarding other articles to us. Here’s a sample:

Robert Keavney, Former Chief Investment Strategist for Centric Wealth, and in 2001 described by Money Management as one of the Ten Most Influential People in Australian Financial Services.

Here's my view on the active vs passive debate. Efficient Market Theory (EMT) argues that the fact that most managers underperform the index is evidence that markets are efficient and that there is no such thing as superior skill.  

However 'the market' largely consists of professional investors. The fact that the return produced by professionals, and amateurs for that matter, after fees and real world costs like stamp duty and brokerage will almost always under-perform the return before these real world costs (ie the index) is so unremarkable as to hardly be worthy of comment. And it should also be added that most index funds under-perform the index by the sum of their fees and costs, though their fees and therefore underperformance will generally be lower than for active funds. Of course, the average net of costs will be less than the average free of costs. How could it be otherwise?

Further, the average fund manager has no superior skill. This can be verified, in my view, by a brief conversation with most of them, quite apart from their lack of superior track record.

The above are strong arguments against investing in an average fund manager.

However, the problem for EMT is that it must argue that no individual or fund manager can ever demonstrate superior skill. According to EMT, investing is unique among all human activities in that it is claimed to be impossible for anyone on any occasion for any single person to display superior skill. A single counter example is enough to disprove the theory in its pure form. Thus Buffet's outperformance has to be completely explained away as pure luck. Closer to home, the Platinum International Fund's almost quadrupling of the index return since its inception in 1995 has to be explained away without any reference to ability or hard word.  

At best the assertion that superior skill is impossible is unprovable. And the attempts to prove it do become intellectually contorted eg Fama/French acknowledgement that small caps and value stocks will outperform the broad index in the long run and that funds which invest in them can do likewise - which would seem to be an acknowledgement that outperformance is possible. But they argue that this outperformance is a result of the market efficiently rewarding the higher risk of value and small cap stocks.  

Another example of intellectually contorted arguments:  according to EMT the price of every stock at every moment is always the correct price reflecting all the information available to the market. When you ask what meaning the word 'correct' has in this context, and how it is measured or verified, you are told that the correct price is the market price. So the market price is the correct price because the correct price is the market price. Nicely circular and thus devoid of content.

This discussion of EMT is, of course, quite separate from the question of whether most people will get a better return by investing in index funds. Few individuals have the ability to identify superior managers so most people in practise will do better to invest in index funds.

Two readers sent in recent articles on the subject. The first is from The Financial Times, with the reader commenting that “I had not thought of benchmarking problems this way, with a very good analogy.” The second is from Reuters and Business Insider.

Predictable rump of index money won’t last, Simon Evan-Cook. FT, 29 September 2013

In April 1831, an accident occurred that forced the British army to change its procedures. The event was unforeseeable, though hindsight makes its causes – and its simple solution – seem obvious. A company of soldiers marched on to the Broughton Suspension Bridge, which began to vibrate in unison with their step. As more troops marched on, the vibrations became more pronounced. Rather than becoming alarmed, the soldiers enjoyed the swaying, even playfully exacerbating it. But as the first troops reached the far side, a bolt snapped, causing the bridge to collapse. Post-crash hindsight may demand that more investors break step, like the army does when crossing a bridge, to prevent disaster ... The risk stems from the widespread use of benchmarks which are synchronising investors’ actions. This is most obvious in passive investing, whose perpetual growth is encouraged despite its unknown consequences.”

Finally, it looks like picking stocks is a winning strategy, David Randall, Reuters, 4 November 2013.

“It’s a good time to be a stock picker. Some 57 per cent of U.S. funds run by active managers are beating their benchmark indexes this year, according to fund-tracker Morningstar. That is the best overall performance for the industry since 2009 and well above the 37 per cent of funds that typically top the indexes.

Stock pickers are doing well in part because after more than four years of marching higher en masse, stocks have started to separate themselves into leaders and laggards. The lines of demarcation became more pronounced during the past few weeks as U.S. companies reported their recent quarterly results.”

There are many useful comments following last week’s article on the Cuffelinks website.


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