the ongoing "active" vs "passive" debate

[Doug]

The following is some advice that one commonly reads. When it comes to stocks, one should invest in REITs and commodities, as they are less sensitive to inflation. When it comes to bonds, one should invest in real return bonds and avoid long term bonds. Real return bonds are less sensitive to inflation, and long term bonds increase volatility for only slightly higher return.

Passive investing is based on the efficient market hypothesis. If this hypothesis is correct, one should do better in the long run with a stock fund representing the broad stock market. Similarly, one should do better in the long run with a bond fund representing the broad bond market.

If one invests in REITs, commodities, real return bonds and avoids long term bonds, does this not imply that the efficient market hypothesis is incorrect?

[Shakespeare]

Passive investing is based on the efficient market hypothesis

No it isn't. See this paper by Sharpe.

[brucecohen]

If CPPIB and OTPP and other successful institutional investors (Yale, Harvard, etc) and perhaps even a hedge fund or two are consistently successful in beating the index, does that not imply that us poor "pure indexer" investors are will see a return lower than the "true index" - i.e. the total return available to all investors?

I don't think so. Much of their success is attributed to markets that small investors can't access efficiently: private equity, real estate and infrastructure. David Swensen, who has run Yale's fund for many years, believes strongly -- almost evangelically -- that indexing is the best approach for small investors. (NPR has several archived interviews with Swensen and they're a delight to listen to. He's the most modest, most unassuming and most friendly money manager I've ever heard.)

[NormR]

Passive investing is based on the efficient market hypothesis

No it isn't. See this paper by Sharpe.

A rather important point seeing as the EMH is a dead theory. (The cost matters hypothesis has always been stronger in my view.)

The notion that EMH is dead might be a bit inflammatory around these parts. But, I'm looking forward to someone explaining why the EMH remains a working theory in the face of counter evidence in the form of the persistent Momentum 'anomaly'. (i.e. empirical evidence.)

[NormR]

Not value investing by default?

Perhaps timid value investing for indexers

[parvus]

Bonsai.

[westinvest]

If CPPIB and OTPP and other successful institutional investors (Yale, Harvard, etc) and perhaps even a hedge fund or two are consistently successful in beating the index, does that not imply that us poor "pure indexer" investors are will see a return lower than the "true index" - i.e. the total return available to all investors?

I don't think so. Much of their success is attributed to markets that small investors can't access efficiently: private equity, real estate and infrastructure. David Swensen, who has run Yale's fund for many years, believes strongly -- almost evangelically -- that indexing is the best approach for small investors. (NPR has several archived interviews with Swensen and they're a delight to listen to. He's the most modest, most unassuming and most friendly money manager I've ever heard.)

Agreed that they have access to investment vehicles the small investor does not have ready access to, but it would seem that they are then "skimming off the cream" of the total universe of investment returns. Would this not suggest that current or future stock market total investment returns for the average investor might be lower than historical averages because a new "elite" class of investors is getting the best return? (I'm thinking that many if these elite instruments might have been part of the market return historically)

[pitz]

Agreed that they have access to investment vehicles the small investor does not have ready access to, but it would seem that they are

But the pension-based entities do not have the same access to leverage as a small investor. The (larger) pension-based entities cannot acquire significant positions without moving the market. Their hands are somewhat tied behind their backs.

Also, anecdotally, it could be argued that many of these new 'investments' (ie: real estate) that are being taken on by the pension plans are in a state of overvaluation. Is a highly leveraged BCE really worth what the OTPP and friends are wanting to pay for it? The public markets certainly disagree, and in fact, continue to disagree. Did the OTPP mess up by unloading a good chunk of their Shoppers Drug Mart position to Shoppers insiders at the bottom of the market in 2001? Absolutely (and I'm very happy to be a recipient of the fruits of their ineptitude). Did they make twice the mistake by unloading the rest in 2004? Absolutely, in hindsight, we can see that the OTPP would have derived much more value from a buy and hold approach instead of playing the market.

then "skimming off the cream" of the total universe of investment returns.

But are they really doing this? Or was private equity buying up businesses and merely structuring them to exploit an arbitrage opportunity between the equity markets, and the excess savings they could borrow inexpensively? How is that really different from someone buying call options or borrowing on margin?

Would this not suggest that current or future stock market total investment returns for the average investor might be lower than historical averages because a new "elite" class of investors is getting the best return? (I'm thinking that many if these elite instruments might have been part of the market return historically)

The 'elite' class of investors are those with low expenses, and long-term buy and hold strategies. Even hedge funds can't beat the indicies on a pre-expense basis, and the situation is markedely worse on an after-expense basis.

[sjhoffman]

Any thoughts on the Rob Carrick - David Feather debate on the benefits of actively managed mutual funds vs. ETFs in the recent issue of Globe Investor magazine found here: http://www.theglobeandmail.com/partners/free/globeinvestor/funds/feb09/openup.html

[IdOp]

Sounds like mostly bombastic smokescreens from Feather, and Carrick doesn't significantly call him out or take him to task. Appropriate material for the fin-pr0n thread.

[Shadow]

Who is this Carosa fellow who's been mentioned here and where can I read his stuff? One of the links in this thread doesn't work.

[Taggart]

The New York Times

The Index Funds Win Again

By MARK HULBERT
Published: February 21, 2009

THERE’S yet more evidence that it makes sense to invest in simple, plain-vanilla index funds, whose low fees often lead to better net returns than hedge funds and actively managed mutual funds with more impressive performance numbers.

[deaddog]

The New York Times

The Index Funds Win Again

By MARK HULBERT
Published: February 21, 2009

THERE’S yet more evidence that it makes sense to invest in simple, plain-vanilla index funds, whose low fees often lead to better net returns than hedge funds and actively managed mutual funds with more impressive performance numbers.

Mr. Kritzman devised an elaborate method to take such contingencies into account. Then he calculated the average return over a hypotheticall 20-year period, net of all expenses, of three hypothetical investments: a stock index fund with an annualized return of 10 percent, an actively managed mutual fund with an annualized return of 13.5 percent and a hedge fund with an annualized return of 19 percent. The volatility of the three funds’ returns — along with their turnover rates, transaction fees and management and performance fees — was based on what he determined to be industry averages.

hypothetical Garbage in; hypothetical Garbage out;
It's hard to believe he couldn't find any actual examples.

[randomwalker]

Mr. Kritzman devised an elaborate method to take such contingencies into account. Then he calculated the average return over a hypotheticall 20-year period, net of all expenses, of three hypothetical investments: a stock index fund with an annualized return of 10 percent, an actively managed mutual fund with an annualized return of 13.5 percent and a hedge fund with an annualized return of 19 percent. The volatility of the three funds’ returns — along with their turnover rates, transaction fees and management and performance fees — was based on what he determined to be industry averages.

hypothetical Garbage in; hypothetical Garbage out;
It's hard to believe he couldn't find any actual examples.

Even if examples of active outperformance were identified they would be identified after the fact. The only useful information with respect to the performance on managed funds vs index funds would the ability to predict which active managers would be the out performers 20 years from now.

[George$]

[url=http://www2.standardandpoors.com/spf/pdf/index/042009_SPIVA-PR.pdf]S&P: Majority of Active Fund Managers Underperform Benchmarks
Across All Categories Over Past Five Years[/url]

Leading Index Provider Releases Year-End 2008 SPIVA Scorecard Results

New York, April 20, 2009– Standard & Poor’s Index Services released today the year-end 2008 results for its Standard & Poor’s Index Versus Active Fund Scorecard (SPIVA).

Over the five year market cycle from 2004 to 2008, the SPIVA scorecard shows that the S&P 500 outperformed 71.9% of actively managed large cap funds, the S&P MidCap 400 outperformed 75.9% of mid cap funds, and the S&P SmallCap 600 outperformed 85.5% of small cap funds. These results are similar to that of the previous five year cycle from 1999 to 2003.

“The belief that bear markets strongly favor active management is a myth,” says Srikant Dash, Global Head of Research & Design at Standard & Poor’s. “A majority of active funds in each of the nine domestic equity style boxes were outperformed by indices during the down markets of 2008. The bear market of 2000 to 2002 showed similar outcomes.”

[Taggart]

The Scotsman

Published Date: 01 June 2009

If you can't beat 'em, why not try the passive approach?

.....So imagine the consternation when Alan Miller, the former chief investment officer of fund management group New Star, recently declared that he had always believed in passive investing.

Miller was paid £3.3 million in 2003 as chief investment officer and manager of New Star's Hedge Fund. Thus for New Star's investment clients it was quite an eye-opening declaration when he let it be known that he has been investing his money in Exchange Traded Funds and index trackers for years while – as Alan Dick, head of Glasgow-based independent financial adviser FortyTwo Financial Planning, bluntly put it to me last week – "earning massive fees and bonuses for under-performing the market with other people's money".