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Passive investing works in all markets

Market efficiency is one of the more controversial ideas in finance. Many academics believe that the stock market is a nearly perfect pricing mechanism for companies. If the market is “efficient” then stocks are correctly priced according to all available information. If stocks are correctly priced according to all available information then there is simply no point in doing any kind of analysis, outperformance would be a matter of luck and not skill.

The active funds industry is based on the idea that stocks are not efficiently priced. Analysts search for undiscovered opportunities, ranging from the “value” approach where one is essentially a bargain hunter, through to the “growth” approach where one looks for companies with superior profit prospects. Whether value or growth, or a combination, or something else entirely, active managers justify their existence with the idea that a skilled investor can identify superior opportunities and can outperform the market.

I am often asked about where I sit in arguments about market efficiency and whether I feel stocks are correctly priced or not. This is, apparently, very important, why would one adopt a passive approach if there were all of those mispriced stocks out there, allowing skilled investors to outperform?

The answer is that I personally believe the market is highly inefficient and agree that skilled investors can outperform the market. However, that doesn’t mean everyone should invest actively. The key factor to note is the idea that trading and active investment is inherently a zero-sum game compared with the market.

You can’t defeat arithmetic

Nobel Prize winning economics Professor Bill Sharpe wrote an article called “The Arithmetic of Active Management”, explaining that active management is a zero sum game.  He showed that it is inevitable that most investors (or more precisely, the owners of half the invested dollars) will underperform the market after costs.

The distinction between “half of all investors” and “the owners of half the invested dollars” is that it might be possible in theory that there is out there a single super-rich and super-incompetent investor or a minority group of such investors, who buy all the bad investments allowing everyone else to outperform at his/her/their expense.  Needless to say, such an investor has never been identified, so for the sake of this discussion you can read the claim as “half of all investors will underperform” and be close enough.  

Sharpe’s argument is simple and elegant, he shows that market efficiency has nothing to do with the success of passive strategies, it all comes down to costs.

First, he defines what “passive” investment is. Passive investment is where you buy every security (stock or bond or whatever) in an asset class, in the same weightings as they are represented in the asset class.

An asset class can be defined however you want to define it.  Traditional asset classes are measured by indexes, but the possibilities to construct an asset class are by no means limited to the ones for which indexes have been constructed. The common indexes in Australian stocks are the ASX/S&P indexes, like the ASX50, ASX100, ASX200, ASX500, the Small Ordinaries index, the All Industrials index, the All Resources Index etc etc.

For example, you could classify the top 100 stocks in Australia (the ASX100) as an asset class, or the 50% of stocks with the lowest price to book ratios, or all the stocks that begin with the letter “A”, or whatever you like.

To take the silly example of the asset class of stocks that begin with the letter A, you are passively investing in that asset class if you buy every stock that begins with A, in proportion to the total capitalisation of each. You would be actively investing if you went through the A companies and judged the merits of each security, adjusting the weightings to each based on how well you expected each to do.

If there were ten stocks in your customised asset class, but you chose not to invest in five of them because you thought the potential of the five you bought to be superior, that is an “active” stock picking decision. An appropriate benchmark to see how your skills have added or subtracted value would be to compare the performance of the portfolio of five stocks that you bought vs the original ten stocks you chose from. It would not be appropriate to compare your performance to some other benchmark, like the All Ordinaries ASX200, or property, or cash, a proper benchmark index is designed to show the performance of the passive purchase of everything in an asset class, so the value of your additions or subtractions from that asset class can be judged properly.

Because we are not limited to asset classes defined by major indexes, it is possible to passively invest in whatever sector of the market you choose to invest in. For example, although there is no official index reflecting these asset classes, Dimensional Fund Advisors have small company passive funds that invest in the smallest one third of companies by market capitalisation (except for the totally illiquid micro-cap end of the market which are virtually untradeable for large investors) and value passive funds that buy cheapest one third of companies as measured by their book value.

A different way to look at it: The Costs Matter Hypothesis

Investment as a whole isn’t a zero sum game, given that asset classes generally offer positive returns over the longer term. If the market goes up 10%pa over the longer term, you’d expect the average investor to make 10% as well, at least before costs.

But active management is a zero sum game compared to the asset classes. Whatever investors do to beat each other, their returns as a group will only match that of the asset class.  The sense in which this is “zero sum” is that for every dollar of returns earned by a superior investor over and above the market’s return, some other investor had to pay that dollar.

Passive investors seek to buy the entire asset class, so before costs their return will be the same as the asset class.

Active investors seek to buy only a portion of the asset class, so individually their returns may be different. If they were skilled or lucky enough to have chosen a subset of the asset class which did relatively well, they will outperform the asset class. However, it should be obvious that this success came as a result of someone else’s failure.

To buy a stock, someone must sell it to you. To sell a stock, someone must buy it off you. It follows then that if you are to outperform, the person with whom you did the trade must have underperformed. Overall, these will net out to zero because all active investors as a group own the entire market, the return on the average actively invested portfolio will be the same as the asset class – before costs.

But investors can’t eat returns before costs, they only get to spend their returns after costs. Costs include brokerage and market impact expenses (such as the “bid/ask spread”), account keeping fees, management fees, entry fees etc. They must also pay taxes, which we’ll get to shortly.

So investors as a group will only get the returns of the asset class, minus the average expenses. If we compare the results of active investors with passive investors, we expect to find that passive investors will do better than active investors, as a group, due to the lower expenses involved with passive approaches.

So the success of passive approaches does not depend on markets being efficient or otherwise, it has nothing at all to do with stocks being correctly priced and everything to do with the fact that markets are zero-sum in nature and costs are the only factor that influences the return, compared to the market, of all investors as a group.


The costs involved with active management can be substantial.  In addition to the obvious ones like fees and brokerage there is also a massive tax expense.  Passive funds generally have very low portfolio turnover (not much buying and selling), which means they tend not to realise gains as often as actively managed funds.  This means that the profit distributed each year by active funds, which is the amount you get immediately taxed on, usually exceeds the amount distributed by passive funds. 

Higher income in itself is not a bad thing, but in the case of funds it generally just means a lower level of growth in the unit price.  There are many funds with turnover of 100%pa or more and these funds tend to have a unit price which has hardly risen at all in many years.  Their pre-tax returns seem ok and are similar to the market, but all of that return has been delivered in the form of taxable income.

The alternative passive fund has basically the same (actually higher, more often than not) total return but it comes in the form of a modest amount of income and a large amount of growth in the unit price.  Since this growth doesn’t get taxed until the investor sells, and then usually at a discounted rate of capital gains tax which is cheaper than the income tax rate, investments which deliver more of their return as growth than income tend to be more tax efficient.

Jack Bogle, the highly respected chairman of the Vanguard mutual funds group coined the phrase “Costs Matter Hypothesis” as a parody of the “Efficient Market Hypothesis”.  He has given a few excellent speeches on the subject, weaving strong logic with beautifully clear explanation.  These include “The Relentless Rules of Humble Arithmetic ” and”Whether Markets are More Efficient or Less Efficient, Costs Matter “.

Market inefficiency: a reason not to index?

An inefficient market, where securities are often mispriced due to shoddy analysis or extreme emotions, is a necessary but insufficient requirement for active management to work.  Even if hypothetically the stock market were quite strongly inefficient and stock picking opportunities were abundant, it would still of mathematical necessity be the case that the average return of investors as a group should be the same as the market and that the owners of half the invested dollars in the market should outperform the owners of the other half of invested dollars in the market by the same margin – before costs – as the latter underperformed.

Market inefficiency does not affect the basic problem that for someone to outperform, someone else must underperform.  It certainly doesn’t guarantee that the person outperforming is the person owning an actively managed fund or hedge fund, nor is it encouraging that despite more than half of all managers tending to underperform they all employ bright marketing people to present their products in the most favourable light possible so that they all, without exception, argue that their products will beat the market and leave those “mediocre” index funds behind.

Huge numbers of books and articles have been written about Warren Buffett, the Sage of Omaha, world’s richest man (his ranking against Bill Gates fluctuates with the relative prices of Microsoft and Berkshire Hathaway, at the time of writing Buffett is richer).  Amateur investors love to quote Buffettisms, discuss “Buffett style investing” and pay attention whenever fund managers try to paint themselves as doing what Warren Buffett does.

Undoubtedly Warren Buffett is an exceptionally gifted investor.  That is obvious, one doesn’t become the world’s richest man (self made, not inherited!) through luck alone.  We have no doubt at all that Warren Buffett is the real thing.

However, Warren Buffett does not provide an example which most people can emulate.  Warren Buffett is to investing what Tiger Woods is to golf, an exceptional talent.  Just as most people can never replicate Tiger Woods’ skills and should not quit their day jobs to join the professional golfing circuit, neither should most investors attempt to invest professionally (all investment is professional, unless it doesn’t involve any money!) just because Buffett makes a good living at it.

The “if everyone indexed, markets wouldn’t work” argument: 

There are a few arguments which seem to routinely get used against passive investing.  One of these is the argument that markets need active investors in order to be efficient.  If everybody indexed, markets would just not function properly.

The argument is silly though.  Truly elite investors like Warren Buffett are never going to index all their money because they have verified skills.   On average, less skilled investors are likely to be the ones who index their money.  If less skilled investors leave the market, efficiency improves.  What matters is the quality of investors, not just the quantity.

At the moment the fraction of investors who invest passively is relatively small.  We are in about as much danger of markets collapsing due to excessive indexing as the economy is to collapsing due to consumers saving too much money.   

Not convinced?  Well what if you heard that there were only two investors offering to buy and sell a stock.  One was Warren Buffett, a noted value investor known for his ability to identify bargain buying opportunities.  The other was George Soros, a famous hedge fund manager who has made billions from exploiting inefficiencies.  If you knew these were the investors on the opposite side of the trade, would you still trade?  Do you want to be the person that sold Warren Buffett his next bargain, or the sucker to buy a stock being short sold by a canny hedge fund manager? This argument is expanded on in some detail by Professor Steve Thorley in his paper The Inefficient Market Argument for Passive Investing.

Thorley actually argues that inefficient markets are even more dangerous for amateur active investors than efficient ones.  The bottom line is that if markets are efficient, then stocks are fairly priced and it is hard to go wrong by buying or selling too high or too low.  If they are not efficient though, it is easy to make mistakes, and investors like Warren Buffett will make vast sums of money buying and selling against less skilled investors.

What if you know markets are going to fall? 

Another great chestnut is the one about indexing when markets fall.  Basically, the argument goes like this: indexing may work really well during bull markets, but what about when you know markets are falling?  In that case the index fund is guaranteed to lose money.  It is at times like that you need active management.

A variant of this argument exists where the phrase “it is a stock picker’s market” is used and abused.

First of all, it is always a “stock picker’s market”.  Very rarely do all stocks go up in all sectors by the same amount.  In theory there are always opportunities for a skilled stock picker to beat the market.  The problem is though that none of the above points about investors as a whole only earning the same return as the market minus their costs cease to apply just because stock markets are down.

If the market is up by 20% and investors incur average costs of 2%, then their return net of expenses must necessarily be on average 18%.  If markets are down 22%, and the same costs apply, then the average investor’s return will be -24%.

There is plenty of data from both bull and bear markets showing that irrespective of what direction the market went, passive funds tended to outperform active funds.

The argument that “if you know markets are going to fall, don’t buy index funds” is based on a big “if”.  Actually nobody really knows when markets are going to fall, and if you did then the correct thing to do would be to get out of stocks altogether, not invest with an active fund with a return which is likely to be even worse than the market.

Markets are unpredictable, but stocks tend to have good returns in the long term.  Passive investors get a bigger share of this, on average, than active investors who incur higher costs.  There is just no way around that, and there is a distinct credibility gap among anyone willing to call for a suspension of the working of basic arithmetic when they say there is.

Why be average when you can put in some work, and be above average?

The idea that passive investing guarantees mediocrity is as hard to shake as it is wrong.  For some reason investors and pundits seem to be unaware of the “costs matter hypothesis” and tend to assume that indexing merely puts you on the 50th percentile, right about average.  A skilled investor, they say, should be able to at least be in the top 50%.

The first problem is that everybody assumes they are in that top 50%, including a great many investors who are skilled, but just not skilled enough.

But the major problem is that you can’t ignore costs.  If the market is up 10% and average costs are 2%, then the average investor will make 8%.  A passive investor paying, say, 1%, will earn 9% after costs.  That isn’t merely average, it is 1% better than average.

But unfortunately costs aren’t really only 2%.  Product fees for actively managed portfolios tend to be at least that high, but often they are much higher.  Add on adviser fees and it is unfortunately not uncommon for people to pay 4 or 5%pa.  Investors with a penchant for hedge funds and alternative assets may end up paying 10%pa or more, which accounts for why most investors in hedge funds tend to get barely more than the cash rate of return.

Then you bring tax efficiency into the equation, and the costs of active management vs. passive blow out even further.

It doesn’t take a mathematician to realise that if an investor is getting a return better than the average investor, they will be beating more than half of all investors. Investors who underperform the market by 1% will be far more numerous than investors who beat the market by 1% and investors who underperform the market by 2% will be even more numerous than the number who beat the market by 2%.

Various studies show good low cost index funds fairly consistently beating about three quarters of actively managed funds, and that’s before tax.  After tax the ranking is even higher.  Top quartile performance on a fairly consistent basis, with superior tax efficiency, isn’t what we would call “mediocre”, and the best part is that the method of attaining this kind of result does not depend on luck, skill or superior insights, only on basic arithmetic.

A good example of the “do some research” claim is made by funds of funds.  There are plenty of products out there, products which tout their expertise in assembling portfolios of superior fund managers selected from the full range of institutional and boutique managers around the world.  These experts scour the globe looking for superior and “undiscovered” managers.

The problem for funds of funds is that they have to report their performance just like all other funds.  Their returns can be readily compared against portfolios with a similar asset allocation made out of index funds.  The results aren’t pretty, and we encourage you the reader to do this comparison yourself the next time you see an advert touting a multi-manager fund product where the words “best of breed”, “best of the best” or similar get thrown around. 

The real reason why hardly any advisers recommend index funds

The notion that we should all be active investors is widespread.  In some cases the explanation is ignorance, in other cases it is overconfidence.  When advisers are concerned those do play a role, but to a large extent the major issue is just one of marketing appeal.  For example, the Diploma of Financial Planning unit 7 (Investment Planning 2) cautions advisers that by using index funds you could run the risk of alienating clients.  

“The brutal reality is that general index funds failed to ignite investor enthusiasm. The lesson for financial planners is that you may lose clients by advocating index funds. … A more palatable marketing technique may be to advocate a sector or segmentation strategy.”

(Source: page 7.32, Diploma of Financial Planning “Investment Planning 2 DFP7″, Financial Planning Association of Australia Ltd and Deakin University.)

They probably are right about the marketing bit, but the industry is supposed to be moving away from a marketing approach and trying to properly educate clients. If clients appreciate that index funds are probably a good strategy for them to use and this has been properly explained then marketing shouldn’t come into it. In fact, I would argue that clients would be more refreshed by an honest approach where the advisor limits client expectations rather than promising to deliver more than they can deliver. Sector investments are a notorious way to waste your money because they invite investors to market time, usually rotating into a sector after a gain but avoiding them otherwise. It is just as ineffective to performance chase sectors as it is to performance chase asset classes.

Ironically, passive investors already have a way to target higher expected returns than the market

Active management is a dubious bet at the best of times, but the biggest nail in the coffin of actively managed funds is that we passive investors already have methods available to us for targeting a higher return. Passive funds which enable investors to increase their exposure to small companies and “value” stocks and emerging markets already exist, and these offer a far more reliable, though hardly guaranteed, method of “beating the market”. 

Passive investment advocates generally maintain however that these variations of passive investing are merely ways of taking on forms of risk, and the returns paid are just compensation for that.

See our article “Investing for Higher Returns ” for a full explanation of this form of passive investment.

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