Paths to Success

Evaluating Costs and Benefits

In discussing costs and benefits, the passive proponent argues simply that the costs of active management are high. There are trading costs, management fees, taxes, and the expenses of monitoring an active manager and replacing him when necessary, not to mention added risk. For him, these costs exceed their benefit, which he sees as the unlikely possibility of alpha. A passive portfolio is substantially less costly to manage.

The active advocate can’t easily dispute the implementation costs, but he feels there is something missing from the picture, some poetry. Active provides a more complex set of softer benefits that count but cannot be counted. Here are a few examples.

Agency arguments. Investors often work through an advisor who provides services including discipline, perspective, connections to good ideas, and a focus on implementation detail. The agent provides personal attention, a human and symbiotic relationship. The presence of an agent brings additional issues, particularly when his compensation is based on performance. Consider, for example, a corporate pension fund officer. Going active gets him attention, customized research and advice, and a convenient scapegoat if things go wrong; his job may even become enjoyable.

Arguments from psychological benefit. When we make active decisions, we are forced to be on our toes. We never stop questioning, pushing ourselves to the edge. Active management satisfies a need for control, perhaps even drama and risk-taking. In contrast, with passive we are etherized.

Many of us derive solace from a search for patterns in noisy data, particularly if we think we can obtain insight, information, or influence. We like to feel in control of our financial destiny, so going active offers hope when markets are down and when times are tough. The passive proponent sees the market as a Japanese pachinko parlor, a noisy roulette table. He tolerates the market uncertainty and seeks his satisfactions elsewhere.

Appeals to authority, status, and uniqueness. Most of us like to believe that we are independent thinkers, superior to that mass of average people. Evolution demands this.

We like to hear success stories, to be associated with winners and to be winners ourselves. So people like Warren Buffett and Peter Lynch become popular authorities, exemplars of active success. This is ironic to the passive proponent since both Buffett and Lynch have pointed out that passive is appropriate for most investors.

Some of us may regard these emotional benefits with cynical disdain. Economists often deride them as being “non-economic.” Or, with the formulated phrases of rational decision-making, they sneer of irrationality. Some money managers and consultants, with their own psychological needs and reasons for doing what they do, disparage them.

But let us not underestimate their importance. Emotion is rational in the sense that it probably has an evolutionary basis. Emotional benefits are a key element of most decisions, and all our purchases involve some notion of emotional well-being. The feeling of control, confidence, and uniqueness that comes with active investment management is a good buy for many investors even at a high price.

Bad Arguments

Because many benefits of active are not quantifiable, its advocates struggle to make their case. In seeking an active manager, we need to avoid the bad arguments.

Arguments from innumeracy discount the key arithmetic of active management. These arguments use data to “prove” successful performance of a population or class of active managers or of the behavior of passive in certain market environments. Arguments have been made that active outperforms in down markets, providing protection when the market crashes, or that active outperforms in periods when value (or growth) outperforms, or that active value managers outperform but that growth managers do not.

Arguments from lack of information claim that passive is blind, insightless, or mediocre. These deny that market prices encapsulate the consensus information and opinion of a large number of informed participants.

Arguments from mean-variance inefficiency express a dislike for the average nature of indexing by proposing another benchmark that is in some way better. They argue, for example, that the market average is not a good place to be, or that market diversification can be improved. A subset are arguments against cap-weighting. Individual active managers often overweight small names at the expense of large names, and their excess performance is negatively correlated with that of large-cap stocks. But these are active notions and need to be justified independently of the active/passive decision.

And then there are arguments that are actually red herrings. There are criticisms of specific index definitions that proceed to the false conclusion that passive is therefore flawed as a strategy. For example, the S&P 500 index has been criticized as posing difficulties, since as a popular subset of the whole market, some exploit its changes and thus affect the movement of its component price. And some active advocates complain that the index is not a good measurement criterion, that their performance should be measured against some other benchmark.

Finally, when appeals to reason fail, there are emotive arguments that criticize passive as a fad, a cop-out, or even anti-American. While there are many good arguments for active, these are not among them.

Wheat Among the Chaff

Many of these arguments contain an implicit plea: I am not average, and neither are you; I have good ideas and they are a better choice. Despite the obvious fallacies in these arguments, we can sometimes find a hidden truth. Calling the index “mediocre” expresses distrust of consensus prices. Complaints of index-relative performance measurement contain a valid kernel: the index benchmark does not evaluate the non-economic and psychological benefits that the active manager provides. If it is an American characteristic to express our independence and always seek the best, then even the anti-American argument may strike near the truth.

However, these bad arguments are disingenuous not least because they distract us from asking key questions of ourselves and of the managers. We should know our reasons for deciding to go active, what we expect to derive in performance and other benefits, and the costs of doing so.

Active management is difficult, and the decision to choose a particular manager needs to be made with care. In interviewing an active manager, we should avoid a focus on past performance. To obtain superior investment returns, the manager should have and be able to clearly articulate an investment philosophy from which flows his superior value. The manager must be able to explain why he is better than the best active managers, not better than the average.

This is not to say that these questions are enough. In deciding to go active we need to do even more work: to evaluate the risks the manager will incur, to consider the investment process, costs, and to perform other duties of diligence.

Yet passive investing is also a difficult concept for many to accept. Its key drivers are a comfort with consensus prices, the difficulty in finding a skilled manager, and the high expense in doing so. We do not need to believe in efficient markets to go passive.

In the end, our question has no general answer; there is a place for both active and passive management. Each must answer the question for ourselves, being honest about our needs and our preferences.