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Passive investing is winning despite the fog of war

Painting of fog of war on a 19th Century battlefield.

According to Vanguard, passive funds are set to double their market share in Europe. Vanguard believes that over the next 10-15 years, passive’s slice of the pie will swell from 15% to more than 30%.

Yum, yum, says the indexing giant. The company already manages $4 trillion of our money but it wants more. It’s now calling for regulators to slap ‘health warnings’ about high fees onto expensive funds.

Maybe we should go whole hog, and insist on gory fag packet-style horror photos inserted into swanky fund literature? Emaciated and impoverished pensioners eating discount pot noodles in the rain, splashed by Cityboys screaming past in sports cars – that sort of thing?

Reuters recently quoted Vanguard’s chief investment officer Tim Buckley in colourful form:

“Active is dying from its own disease, it’s dying from its own greed. It’s high-cost against low-cost, and high-cost is the dinosaur.”

Ouch! Don’t ask Mr Buckley if your bum looks big in those.

Zero mercy

Tighter regulations such as MiFID II are set to further increase the cost of running funds. Ironically, this will probably also decrease competition by making it harder for new entrants to get started.

My own cursory look into the costs of setting up a little fund manager has persuaded me that to get rich running other people’s money, I’d have to be rich to begin with.

Low costs mostly come from economies of scale. So it will be left to the current incumbents – active and passive – to slug it out in a price war.

Vanguard has feet in both camps. Few realize Vanguard manages around $1 trillion in active funds. Low fee active funds, of course.

And costs matter because active investing is a zero sum game.

Well, almost a zero sum game. Probably. There are a few quirks that muddy the waters.

Previously we’ve not had to pay these too much attention. Some make your brain hurt. But as passive investing grows and eats up the investing landscape like a sci-fi blob from the 1950s, people are going back into the footnotes of the passive thesis and looking for caveats.

I’ll do so too in a future post. I’m no professor of economics, but for what it’s worth I believe these quibbles are of academic interest at most to the average investor, and don’t change the main argument for using market cap weighted index funds.

Zero tolerance

Anyway, many people even haven’t grasped the main argument yet. Let’s have a quick reminder.

Investing in itself is not a zero sum game. You and I can both make money in the stock market, without competing against each other.

As the economy expands, the total sales and profits of listed companies will grow. As owners of companies – whether through active or index funds – we’ll benefit as the market puts a higher value on our firms churning out ever heavier wheelbarrows of cash. We’ll also get dividends from the companies we own, whether via direct shareholdings or through funds.

So far, so good for everybody.

Here’s the zero sum bit. In order for £1 that’s invested in an active fund to win against the market – that is, to outperform the market – somewhere £1 of active money has to lose.1

That’s because ‘the market’ consists of only passive indexing and active funds.

And passive funds follow the market, so we can net those out.

This leaves the active funds (which includes smart beta ETFs and the like) trading amongst each other.

They profit at one another’s expense, but in aggregate they earn the market return.

And as they also charge higher fees, they must therefore do worse than trackers.

This logic was established more than quarter of a century ago by Nobel Prize-winning author Bill Sharpe. Read his paper, The Arithmetic Of Active Management, and see for yourself.

However be warned you might still feel befuddled afterwards.

I don’t blame you. It took me years to properly wrap my head around this stuff. I’m sure there are old articles on this website that aren’t completely on-point.

Active investors say the funniest things

You see passive investing is a weird concept. It feels wrong compared to our everyday experience. I’ve noticed even many financial professionals don’t really understand the theory behind it.

You might have heard journalists or fund managers say things like:

“Now is the time when stock picking funds will prosper over passive.”

Or perhaps:

“In this particular area of the market, active funds will always beat index funds.”

If you follow the zero sum logic of investing, you know such statements must be false. Maybe you’ve even rolled your eyes at their self-serving deception.

However I’m confident that in some cases those people don’t actually understand the active/passive arguments.

Here are some other wrong-headed things I’ve heard recently – in person and in the media – that I’m pretty sure weren’t meant as deliberate falsehoods:

As more people invest passively, it’ll definitely be easier for active funds to beat the market.

Active funds will do much better than passive when markets are falling because they can get out of expensive stocks.

Active funds can prey on the dumb money in index funds.

Index investing is Marxist.

The growth of passive investing has made markets less efficient and more volatile.

Index funds are poor performers, but at least you don’t pay much for their poor performance.

When you want the best brain surgery, you pay for the most expensive surgeon. Same thing applies with investing.

Passive investing is dangerous, because the dotcom crash / financial crash / whatever proved markets are not efficient.

Or: Markets need to be super-efficient for passive investing to work – and they’re not.

A hard-working fund manager can always beat the market.

You should invest in index funds because no active managers can beat the market.

The advanced version: You should invest in index funds because no active managers can beat the market over the long-term.

I haven’t got time to watch CNBC for 10 hours a day, so I just invest passively. It’s better than nothing.

Most of these dubious statements stem from not understanding the zero sum argument or not thinking about what it means to say markets are efficient. People also forget the huge role of luck.

But rather than debate each point myself, I’m going to direct you to a podcast on Bloomberg. (Unfortunately I can’t embed it here.)

Poker, passive investing, and a podcast

The latest episode of Bloomberg’s Odd Lots podcast – How Poker Explains The Battle Of Active And Passive Investing – centers on a paper by Michael Mauboussin, a bigwig at Credit Suisse who has long been unpicking the role of talent and luck in investing. (See his book The Success Equation).

The hosts of Odd Lots are smart, and I listen to their show most weeks.

However to illustrate my point, at least one of them doesn’t seem to understand the zero sum aspect of active investing at the start of the interview – and I’m not sure about the end, either.

But Mauboussin is patient and convincing, and well worth listening to. He’s interested in the game of active investing as well as the remorseless logic of passive. (A kindred spirit!)

Mauboussin also briefly mentions a couple of those edge cases that people sometimes bring up to contest the zero sum thesis.

As I say these – and the others he doesn’t mention – don’t change the best practical approach for everyday investors, as far as I can see. Certainly not right now, in 2017.

They will also not support a multi-trillion dollar active management industry.

After all, even if there are loopholes in the theory, the woeful market-lagging performance of most active funds in practice means such caveats are barely relevant in the real world:

Vanguard found 64% of active funds underperformed in the 15 years to the end of 2016.

Source: Vanguard/CityWire

Pretty compelling. Still, the arguments raised against the pure ‘zero sum’ mathematics do stretch your brain a bit. I’ll take the pain in a future post.

For now, get up to speed with the Bloomberg podcast. It’s a good listen.

  1. Those caveats notwithstanding. []
{ 31 comments… add one }
  • 1 Oscar Cunningham February 22, 2017, 3:47 pm

    The “percentage of active funds underperforming” statistic always seems a bit irrelevant to me. Would active funds be better if most of them beat the market but some lost massively?

    (Actually I’m surprised the skew isn’t that way around. If you’re charging two and twenty then you make more money by outperforming a small amount most of the time and then taking a huge loss (which you don’t pay the 2% on) occasionally.)

  • 2 seamus February 22, 2017, 4:31 pm

    Terry Smith in the FT on Saturday 17th Feb 2017 >>
    `Emerging market ETFs and the jaws of death
    Huge inflows have gone into the largest companies — but they are not good companies`
    He makes the case that Market Cap focussed ETF`s drive up the price of larger cap shares while leaving some smaller, well managed companies, share prices lagging.
    Many of these smaller better managed companies will outperform their bigger competitors and so prove a better buy.
    Some sense in that I reckon……

  • 3 Mark February 22, 2017, 4:53 pm

    I think there are some fairly basic errors of logic and of fact in the active versus passive argument. These include:

    – The fact that the majority of active funds underperform the index does not necessarily mean that, on average, actively invested money underperfoms passively invested. Active funds may, on average, be smaller than passive ones

    – There’s also the question of which index, if any, an active or indeed passive fund should be compared with. Some of the best active funds are not closet trackers, so may deviate from an index significantly in composition and hence in performance, so may exhibit periods of underperformance against an unrelated index despite outperforming it over the long run

    – Even if it were true that, in aggregate, all actively managed funds underperformed the passively invested, it need not follow that the customers of active funds would suffer impaired returns. Most active funds follow a single, defined strategy. There may be periods when that strategy will lead to poor performance. Customers can minimise their exposure to those periods by switching funds. For instance, money flowed out of commodity funds as the Chinese economy slowed a little over a year ago, and returned to them the middle of last year. Since then, returns have been great

    – The zero sum hypothesis is wrong, in that it’s untrue that the market consists only of actively and passively managed funds. There are also direct purchases of individual stocks and activities such as shorting and stock lending

    – Recent years have seen sizeable inflows into passive funds, especially low-cost ETFs and their US (Vanguard) equivalents. With all this money buying into the popular indices, is it possible that their seemingly attractive performance is at least in part due to the momentum effect – the additional capital is driving the outsized returns? Likewise, could outflows from active funds be a factor in lacklustre performance, especially in the case of unit trusts and other open-ended vehicles which must sell holdings to honour redemptions?

  • 4 The Investor February 22, 2017, 4:56 pm

    @Seamus — I heard that piece, and also read Smith’s article. This is the sort of thing I’ll be exploring in the second part at some point. (My draft already has a link to his piece! 🙂 )

    I don’t think Smith has identified anything new here, it’s an old argument. I believe it’s one of those things that sounds sensible, but is actually one of the misunderstandings.

    It is active investor trading that determines the relative valuation of companies in the index. Passive funds simply follow the index as determined by active investor trading. If the smaller companies are now better value, then active managers should be selling the large companies down and buying the smaller companies, driving up the smaller companies multiples and valuations, and reducing the valuation of larger ones. If they’re not, it implies more active managers think the big companies are worth the money, at least relatively speaking.

    Essentially, he is simply saying that the largest companies in Emerging Markets currently are not the sort of companies *he* thinks should command high valuations, as far as I can see.

    In the US market for instance there are totally different companies at the top of the market cap pyramid (Apple, Google, Amazon and so forth).

    In the UK, Europe, and the US we’ve also seen huge passive fund inflows — and at the same time very high historical valuations on the sort of companies Smith *does* like. (Bond proxy style companies with good cashflows and strong brands). I notice however that he is reserving his complaints about passive inflows distorting valuations for the emerging markets (where his emerging market fund has been underperforming) and not developed markets (where his older equivalent fund has had a very strong few years, on the back of that preference for bond proxies).

    This is the sort of thing that makes people cynical, though Smith is I believe one of the good guys all told. 🙂

    I do think it’s fair to say that huge inflows into a market will drive up valuations *generally*. But that would be equally true if the money were going into active funds, which would after all still have to put the money to work somewhere. (See the Dotcom boom).

    Looking forward to more comments and discussion — and other angles on this. As I say it’s not my specialist subject, and it does hurt the brain a bit to think about. 😉 But I will probably save most of my thoughts for that second piece, otherwise I’ll end up writing it here in the comments! 🙂

  • 5 dearieme February 22, 2017, 5:28 pm

    The Laws of Investing (setting aside any discussion of British house prices):

    Zeroth: invest passively in any market capable of supporting passive investment.

    First: if you want growth in real terms you must expect to have some, perhaps most, of your money in equities.

    Second: let your other investments be in assets whose correlation with equities is zero or, better, negative.

    Third: minimise taxes and fees.

  • 6 Neverland February 22, 2017, 5:39 pm


    “The fact that the majority of active funds underperform the index does not necessarily mean that, on average, actively invested money underperfoms passively invested. Active funds may, on average, be smaller than passive ones”

    Smaller funds cost more in % fees than large ones, doubly so if they are actively managed. Higher fees and expenses are the one of the major things that stops active funds being able match the performance of passive funds on average

    The other dirty secret of active fund managers is survivorship bias – underperforming funds are quietly closed or merged to take them out of statistics and make average active fund performance look better than it actually is

  • 7 Olivier February 22, 2017, 5:47 pm

    I generally agree with the arguments for passive va active in markets that are fully liquid, with negligible transaction costs.
    2 things to note though :
    1) skill matters if transaction costs are large, so if markets are illiquid active funds as a class may outperform passive funds purely due to better execution.
    2) you have include retail investors in the ‘active’ bucket. If there are enough retail investors investing poorly, a professional active fund can outperform the benchmark ( an arguably that’s why they used to have a good run )

  • 8 Jed February 22, 2017, 7:48 pm

    @mark, Some actively managed funds do outperform passive funds that is true. The problem for an investor is to identify the funds and then to identify how long a period the fund will outperform. If you could do this then you are in the money. If you cant then you could invest in a fund where you underperform the index over a period of time or worse. At least with passive you get average returns.

    @ investor Price war, bring it on the cheaper the better. Tim Buckley isn’t wrong with his comment, there are examples everywhere, how about 100% charges http://www.thisismoney.co.uk/money/pensions/article-4224958/9-000-David-saved-pension-worth-nothing.html

  • 9 IanH February 22, 2017, 9:34 pm

    Here’s a thought about active vs passive investing risk – where risk is taken as the statistical variability of the outcomes. A passive portfolio including all the items in the market population has a certain variability. Of these items 10% turn out to increase in value the most, and 10% decrease the most, and an active investor would want to pick the top 10%, say the green ones, and not the red ones, if we could see their colours at the outset. If you can do this the variability of the green winners is less than the population variablility as a whole (as is that of the red losers). Unfortunately if you are colour-blind to the winners and losers, and get half and half, then your total risk turns out to have been substantially greater than the chap who just picked everything.

    This seems to me to match how people feel about this too. It would be worth a premium to pay for someone to spot the green items among the rest. But what if, as seems likely, we are colour-blind to future value?

  • 10 Naeclue February 22, 2017, 10:04 pm

    I think one must be careful how passive and active are defined. For example, people who invest in a a couple of dozen shares and sit on them indefinitely might legitimately consider themselves passive investors. Similarly, are the myriad non-cap weighted index trackers, such as dividend aristocrats, value trackers, growth trackers, high yield, etc. passive or active? For the sake of a logical discussion, I think it is required to define passive as meaning investing in a large proportion of the shares in the market by cap weight. So for the UK market, a FTSE all-share tracker for example would be more passive than FTSE 100 tracker or something like Vanguard’s FTSE U.K. Equity Income Index Fund.

    By this definition, passive investing is completely market neutral and does not alter demand for one share over another as passive money enters or leaves the market. It is the other participants, individual investors, active fund managers and the demand for non-cap weighted trackers that sets prices. If there was huge demand for a Dividend Aristocrat ETF, or even for FTSE 250 trackers, that demand would feed into prices of the underlying shares just as much as huge demand for particular shares from actively managed funds. These non-cap weighted and/or not full market tracker funds also have to buy and sell shares as shares enter and leave the index being tracked. This alters relative demand for those shares.

    With a FTSE all-share fund, there is equivalent demand for every company in the index when the fund purchases shares and so any resulting price pressure will be the same for every share. This is an area that is very misunderstood, leading to incorrect claims such as demand for trackers pushing up the price of the highest valued shares. Anyone making such claims does not understand how market index trackers work, or does but is attempting to undermine cap weighted trackers.

    Given the definition “passive investing means all of market investing by cap weight”, then all the money in non-passive funds/portfolios must perform the same as all the money in passive funds before charges. But the non-passive proportion as a whole absorbs more money in trading costs and fund management fees, so that money must perform worse than the passive money.

    The underperformance of the active money might be small in any one year, but that underperformance compounds up as the years roll by. If a FTSE all-share tracker has an inflation adjusted CAGR of 4% over 20 years, that is 119% real growth. If the total costs of all the active money trading FTSE all-share stocks is only 0.5% more, over 20 years that means a reduction of the money made on those stocks of 20% (99% real return instead of 119%).

  • 11 david m February 23, 2017, 1:26 am

    Looking at UK FTSE All Share index trackers with a ten year record (to 30/12/16 in my monthly magazine) I found 13 of them with an average total return of £164 on £100, and a range of results from £155 to £170. This compares to the index total return of £172.

    My preference is for active UK equity income investment trusts where the average return from 21 of them was £181, with a range from £114 to £269. 11 beat the index and all the trackers, 5 were in the range of the trackers, and 5 underperformed all of the trackers.
    It seems to me that a tracker would cap the downside but also cap the upside, so I will continue to try and pick the best active UK equity income investment trusts. I appreciate that trackers will be better suited to other investors including new investors.

  • 12 Amit February 23, 2017, 9:05 am

    I wonder if most of the stock pricing / mis-pricing is not because of active funds preferring to buy expensive stocks – but because their lay clients pile on to high conviction funds with a certain asset allocation. A recent example would be the swelling of Fundsmith Equity when bond proxy was in fashion. I would imagine a lot of that would also have happened prior to the dot com bust i.e. investors would have piled on to tech heavy funds. I would imagine the conservative funds like Warren Buffet’s would not have been in fashion – and possibly became in fashion in the aftermath. A lot of conjecture – anyways the point being I don’t think active funds are necessarily to blame for their underperformance – it is the underlying investor base’s biases that leads to alarming mispricing. As a rational investor, my knee-jerk reaction would be to buy a value fund as an all-weather fund, rather than buy a passive fund – but I can see your point too.

  • 13 John B February 23, 2017, 9:33 am

    @david m what happens if you weight return by fund size, for both trackers and ITs, so you have 2 numbers, return if picking a random fund (I assume big funds have better advertising)

    Do you know what IT discounts/premiums were at the start and end of the period? ITs, rather than general active funds, do have special market timing characteristics.

    When you were choosing your lists, how many ITs at the start of the period had vanished by the end, and how many new ones had appeared, that you couldn’t apply the calculations to?

  • 14 john February 23, 2017, 9:41 am

    Yes some good points above. Active managers are usually constrained to a certain universe or style, so the investors are actively allocating capital by picking funds. It also means that as passive money pours into mega caps, there’s not an efficient method for active managers to correct it.

    Active does seem to be dead in the long term. As long as there are many thousands of retail investors willing to spend vast amounts of time valuing companies for an average loss, everything will be fine, right TI? I think there is a genuine worry here.

  • 15 Malcolm Beaton February 23, 2017, 10:52 am

    Hi All
    Just finished reading A Man for all Markets by Ed Thorp-autobiography
    Here is a man who consistently “beat” the market and has a track record to prove it
    Easy and clear to read.
    Obvious how he did it-he is very clever-a mathematical genius and all round exceptional guy
    Not me unfortunately but I am clever enough to know it!
    I suppose if early enough in your investing career you can spot one of these guys -hang on for the ride-but difficult to separate the good from the “chancer”
    Passive indexing for me
    The only other point I would make is that as Passive funds take up more of the Stockmarket they get increased responsibility for the companies they invest in
    I note that Vanguard is starting to do this -querying CEO,s salaries and compensation packages.

  • 16 Andy February 23, 2017, 3:04 pm

    Any other podcast recommendations?

    Alternatively, start up your own here @Monevator 🙂

  • 17 Naeclue February 23, 2017, 3:33 pm

    @david m I had a look at the AIC web site for UK Equity Income trusts. This group seems to comprise quite a disparate bunch of trusts. The top 2 over 5 years are quite clearly small cap funds and the third, Finsbury Growth & Income invests 20% outside the UK and has a yield of only 1.9%. I am not sure what any of these are doing in a sector called UK Equity Income. The Finsbury fund by the way is the only one in the group to have beaten the FTSE World Index over 10 years, with a return of 172% compared with 141% for the FTSE World Index. World tracker funds, or a portfolio of trackers approximating the World Index, don’t take unnecessary risks to achieve their returns either, such as the use of gearing or going overweight small caps or private equity.

    I can understand why someone might want to buy an actively managed fund for the chance of beating the index. I would myself, but for the fact that evidence suggests that over the long term I would be much more likely to underperform a world tracker than outperform it. For me this pragmatic, evidence based fact trumps any theorising over how actively managed funds might or might not be able to outperform a tracker.

    I suspect that a lot of the money that has moved from traditional actively managed funds to passive funds has ended up in pseudo-passives, such as factor based funds, so-called smart-beta, dividend aristocrats and other such funds which are really just actives in disguise, rather than it all going to whole of market, cap weighted trackers. Active investing will still exist, it will just change into a different form and the fees will come down.

    I noticed a little while ago that Vanguard have released 4 of what they call actively managed ETFs at what seems to me to be a very low price, comparable to the price of a world tracker. If I wanted to take a punt on active management again, which I don’t, I would give those ETFs some serious consideration.

  • 18 Naeclue February 23, 2017, 3:56 pm

    @olivier, regarding this:

    1) skill matters if transaction costs are large, so if markets are illiquid active funds as a class may outperform passive funds purely due to better execution.
    I would tend to agree that active managers could have an edge here, but passive funds tend not to invest in illiquid assets (at least not equities). For example, it is not possible to buy a FTSE small cap tracker.

    2) you have include retail investors in the ‘active’ bucket. If there are enough retail investors investing poorly, a professional active fund can outperform the benchmark ( an arguably that’s why they used to have a good run )
    Agreed, but the point being made in the Bloomberg podcast is that retail investors are increasingly fleeing the market into passives. That makes it difficult for the remaining professionals as there are fewer punters to fleece, just other professionals.

    I am sure that active managers performed far better in the past, certainly in Benjamin Graham’s time and when markets were less efficient. In the past fund managers could benefit from better access to information and even inside knowledge.

  • 19 Richard February 23, 2017, 4:20 pm

    My active investing is how I allocate my passive funds (so I do the active investing glup!). I don’t have a global tracker. As previously stated I overweigh UK with UK index tracker, then I overweigh a bit in emerging markets with a tracker there and will underweigh US and elsewhere As a result. I do hold a UK small cap active fund to try and increase my small cap exposure that the UK index fund doesn’t do so well. Mainly because I couldn’t find a small cap tracker. So I try to beat the global market with risky investments in small caps and emerging market.
    This made sense when I put it together, but I haven’t properly benchmarked it to see if it actually is doing better or worse than a global tracker. Need to do that and then perhaps think again.

  • 20 david m February 23, 2017, 5:41 pm

    @John B
    I haven’t got a size weighted average on the unit trust trackers. The size weighted average on the investment trusts are £192.50 share price total return on £100, and £186.90 net asset value total return on £100. This reflects that the bigger trusts are mostly better performers. This suggests also that discounts narrowed by about 3%.
    The sector discount at the start and end of the ten years were 4.9% and 4.2% which shows some narrowing.
    The make-up of the sector did change with 4 trusts transferring in and 1 transferring out from other sectors, ignoring split capital units.

    If investing in UK equity income investment trusts you would need to actively look “under the Bonnet” as you have done when choosing which to invest in. Most are large cap funds with yields just above the index, but some are not.
    The FTSE World Index is benefiting from the strong US performance and recently the pound weakening. It’s more difficult to find UK or Global active funds that can beat it, but I’m not sure I want that much exposure to an arguably over-valued US stock market.

  • 21 Naeclue February 23, 2017, 6:14 pm

    @david m The UK stock market has also benefited from pound weakening.

    I agree that over the last 10 years, the World Index has greatly benefited from strong US performance. The whole point of passive index investing is not to try to second guess the markets. I am sure if I did try I would have heavily reduced my exposure to US stocks years ago and had my returns suffer because of it. At some point I have little doubt that the US market will go through a period of below average performance, but I have no idea when that period will commence or end, so no clue as to how to profit from it.

  • 22 david m February 23, 2017, 6:30 pm


    Even passive investing involves a choice of index and certainly the World Index has been a good place to be for the last ten years.

  • 23 Uncertain February 23, 2017, 8:44 pm

    My main concern if too much money goes passive is that the economy as opposed to the stock market becomes inefficient..
    Allocation of capital is important to the efficient running of an economy and at some point someone has to make a decision about how to allocate their occipital if there are lots of people doing it an a market place with different ideas you get an efficient market economy. If everyone is putting it into cap weighted indices whether stock or bond you are not likely to get efficient allocation of capital.
    Companies requiring equity capital cannot get it unless they have an existing listing and then how do you decide how to do a placement?

    This is not a rejection by the way of index funds of which I hold a number but why I also have some active funds as well and a very few private equity funds.

  • 24 Naeclue February 23, 2017, 9:28 pm

    @david m I would say that the World Index has been a good place to be for much longer than 10 years. It will never be the best place to be as it will always be possible to find some other index and some actively managed funds that will have beaten it over some period, but it will never be the worst place to be. I am happy to settle for it being an average index (weighted by global stock market sizes) and one that beats well over half of the actively managed funds available, and with reasonably low volatility. Index investing isn’t about trying to get the best return, it is about getting average to better than average returns with minimal effort.

    @Uncertain This would worry me to, but we are a very long way from that happening. As I said previously, the various smart-beta, etc. funds are forming a new form of active investing. Smart-beta is going to be useless if no-one is prepared to estimate forward valuation metrics.

    Don’t forget as well that we are only talking about secondary market valuations of bits of paper here. Capital gets allocated to companies when they raise capital through IPOs and rights issues. Capital only gets deallocated through dividends and share buybacks. Mergers and acquisitions reallocate capital. As long as these real allocation, deallocation and reallocation processes happen efficiently I cannot really see it matters too much if secondary market valuations are at times not as efficient as they should be. Inefficiencies in secondary market pricing create opportunities which will be be exloited at the very least by real companies operating in the market. That feedback on its own should keep markets efficient enough.

  • 25 mr_flibble February 24, 2017, 12:37 am

    The argument for active investing being a zero net sum game seems to be correct. However, perhaps this argument is being thought about here in terms which are very equity-centric. If we move away from equities, then I’m puzzled why active funds as a whole cannot outperform. Take hedge funds that focus on interest rate derivatives as a example. By construction derivatives are a zero net sum game (in the sense that for every person who is borrowed an interest rate swap there must be someone else who is lent the same interest rate swap; the net P&L is always zero). However, not all players in that market are investors; for example some may be corporates hedging interest rate exposure or central banks doing fx swaps etc. There is then no reason why the subset of players we might call “active investors” cannot turn out to be net positive in return terms, while another set of players, lets say corporates turn out to be negative in return terms. As the objectives of those players are completely different i.e both can win relative to their metrics. The corporates are hedging risk, and are willing to pay away returns in exchange for certainty, while the active investors are speculatively taking on that risk and need to be compensated for that activity.

    It’s also not clear to me why you want to use performance vs. an index as the relevant metric (so thinking in terms of alpha or information ratios) rather than in absolute return terms (or Sharpe ratios). Take some HY corporate bond or emerging market debt indices, which are debt capitalization weighted. As the issuer increases their debt burden, their weight in the index increases. I don’t see any reason to want to passively track such an index.

    My equity and government bond portfolios are almost completely passive tracker products. However, for that part of my portfolio that is focused on low-correlation absolute returns or even for more “off-piste” beta (in EM local markets say or loan financing etc), the last thing I want is to passively track a poorly constructed index. Perhaps I’m doing something very wrong!

  • 26 Fremantle February 24, 2017, 11:48 am


    My understanding is that in that stock markets provide liquidity to entrepreneurs and other risk capitalists. It is entrepreneurs and their initial investors that allocate (and create) capital to private enterprises, then float their investments on the stock exchange to either raise more capital or take profit. Either way, index funds do not interfere with this process, but are merely obliged to buy successfully floated company stock when it enters the index.

  • 27 Charlie February 24, 2017, 1:17 pm

    @Andy re: other podcasts

    Get yourself a podcast app such as Podcast Addict and search for…

    Canadian Couch Potato
    TEBI Podcast
    FT Money Show
    This is Money show
    Money Box (Radio 4 podcast)
    Wake Up to Money (Radio 4 podcast)

    There’s a raft of non-money related ones too that help make commutes more pleasant…

    Freakonomics Radio
    Chequered Flag Formula 1
    The Infinite Monkey Cage

  • 28 raluca February 24, 2017, 1:29 pm

    Sure, passive investment is winning … in advanced markets. I don’t live in such a blessed country. We have a small stock-market and no passive funds to invest in. So I’m an active investor, not because I want to, but because that’s all I can do and I turn to Monevator for my weekly dose of wisdom, in 1500 words or less :).

    Maybe that’s where active investors and funds will go in the future. Emerging markets, frontier markets, anywhere where scale is more of a hindrance than a benefit. Sort of like where Warren Buffet is too big to invest :).

  • 29 Jim McG February 24, 2017, 2:41 pm

    Merryn Somerset Webb’s most recent Moneyweek Podcast interviews a fund manager who is a fantastic advert for passive investing. Apart from being an arrogant baboon, he thinks Index funds are “bonkers”, is a self-confessed complete contrarian (ever met one who isn’t?) invests in unloved companies in unsexy sectors (don’t they all) and never buys – for example – retailers. Oh, wait a minute, he does. Okay, he never touches banks. Oh, wait a minute, he does. As the podcast goes on you just can’t escape the conclusion that he either doesn’t know what he’s talking about, or that he really doesn’t know what he’s talking about. Poor Merryn, what a waste of time, and if she wants she can get in touch with me so I can put her over my knee and ….excuse me, I need to go and lie down.

  • 30 Andy February 24, 2017, 5:06 pm

    @Charlie re: podcast recs

    Thanks very much, a few on my list already (I use Pocket Casts on Andorid – I’m a sucker for a nice UI :)) but some very welcome additions, thanks for posting.

  • 31 Naeclue February 24, 2017, 5:30 pm

    @mr_flibble I don’t invest in HY debt, but I can still see the logic of buying a tracker. Companies that have issued a lot of debt are also likely to have a lot of assets/equity. What matters is the balance between the 2 and the market perceived likelihood of default. If a company issues too much HY debt compared to its assets, that will be reflected in the price of the debt, regardless of the actual asset value of the company.

    There is only a finite amount of HY debt to invest in, so the same arguments about cheap passive vs. expensive active must apply to that market as much as it does to equity markets. The active holders are competing against themselves and setting prices. The passive full market tracker gets the same return as the active market before costs, but has lower costs than the active market participants.

    I cannot see any reason why any market which trades in pieces of paper, debt, equity or cigarette coupons for that matter, cannot be arranged into an all of market index and the same arithmetic then applies – the trading costs and fees of the active side will be larger than the passive side. If there are a lot dumb active participants, the smart participants should be able to take money off them. I used to work in finance and ca assure you that active debt market participants are very clued up. There isn’t much dumb retail involvement to take advantage of.

    Going off topic now, but I don’t really understand what you have said about interest rate swaps. These are OTC deals, typically between a corporate client and a bank to swap one cash flow stream for another. For example, for 30 years one side might pay 3M LIBOR + 0.5%, and receive 2% fixed. At regular intervals the payments are netted and either FIXED pays FLOAT or FLOAT pays FIXED.

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