The Irony and Internal Contradiction of Passive Investment Management

My relatively snarky post on hedge fund fees and passive management got a lot of response, including a few of challenging emails from friends and acquaintances.  So I wanted to cover a few followups here.

One of the interesting features of passive investment management is that it doesn't work if everyone does it.  I vaguely remember there is some name for this in the game theory world but I can't for the life of me remember.  Anyway, passive investment is based on the theory that the market for financial products is relatively transparent and efficient.  While one stock will certainly perform better than another, it is almost impossible (or at least really expensive) in a mostly-efficient market for a regular investor, or even an average fund manager, to parse this out.  As a  result, high fees or expenses one might incur to find these opportunities generally don't pay for themselves, and it is better to just invest in a broad basket of securities and accept the average market return.

But note that this is predicated on the assumption that someone, somewhere is actively managing.  Someone must be looking for good stocks and bad stocks and buying the former and selling the latter.  Without these folks actively managing, it would not be an efficient market.  [I am reminded at this point of the old joke about a man walking down the street with an economist.  The economist steps right over a $100 bill on the sidewalk without stopping.  The man asks the economist, "why didn't you stop and pick up that money?" and the economist answers, "in an efficient market it can't really be there."]

I remember a while back reading economic research about shopping.  What percentage of customers have to be active price-shoppers to make a market efficient?  I personally don't price shop for the small stuff.  If I need a bunch of cheap bulk stuff, I just run to Wal-Mart or Costco and buy it with confidence I am getting a pretty good price.  But why can I do that?  Because I trust these large corporations to honor their promise for low prices?  Hah!  No way.  What I trust is that there are people who clip coupons and price every dang item to the penny, and it is these folks who keep Costco and Walmart honest.  Government interventionists like to talk about the free rider problem all the time, but most all of us are free riders on these hard core shoppers.

The same is true with us passive investors.   I like to get snarky about the fees certain active investors charge, but I am still dependent on their work.  And I don't particularly doubt that there are hedge funds and private equity firms that make consistently above market returns, but I do think they are a minority.  I would equate it to max-contract players in the NBA.  No one doubts Lebron James merits a max contract -- any of the teams in the NBA would sign that deal in five seconds.  But a max deal for, say, Chandler Parsons?  Joakim Noah?  The problem with hedge funds is that the few of these folks who merit the two and twenty max contract have very likely been closed to new investors for years, in the same way it is impossible to get LeBron James to play for Memphis.  It is frustrating for me to see public and private institutions chasing yield and continuing to pay 2 and 20 to folks with an unproven algorithm and a marketing plan.  If I am going to pay 2 and 20, its more likely to be to someone in private equity or an LBO fund who is doing more than stock picking.  That's because I do think that stocks are generally well-valued on the market based on their current management, investment plans, culture, etc.  But they may contain opportunities for smart people who can come in and, for example, apply different management and culture and strategy to the people and assets.  A box that is half Kale and half candy corns might not sell for a good price because no one wants the combination, so value can be created splitting it up.

A couple of other thoughts that came up in discussions since yesterday:

  • I am willing to believe that passive investing looks so good vis a vis active investing because central banks have inflated assets and compressed volatility.  If all the boats are rising with the tide of state actions that are raising the tide, then one is less likely to be fussy about which boat he is on.  What's the point of value investing when the market treats stocks as commodities?  But I can certainly see that in markets like the late 70's or pre-market-boom early 80's that stock pickers might have had more room to differentiate themselves.
  • I am also willing to concede that passive investing may turn out to be a terrible trend for corporate governance.  If all your shareholders are just holding your stock as part of a basket of 500 stocks, who is going to hold you accountable?  It is very awkward for a Vanguard agitate for changes in a company, even when they might be the largest single shareholder.  Also, ironically, passive investing may be opening the door for single lone wolf activist investors to impose their will on companies, sometimes to the other shareholders' detriment.  If one person with 5% cares a lot and the other 95% are passive, that one person might be able to raise a lot of hell.

As a final note, I am a screaming hypocrite on the whole passive investing thing, since with most of my net worth I am the ultimate in active investors.  I have most of my savings in one company, the one I run.


  1. Sonartech:

    I'm just going to put my money in the mattress.

  2. Ann Ominous:

    There is an optimal amount of effort for the market to spend on price discovery. If passive investing beats active investing by a significant margin, that means we're spending too much on active investing.

  3. Craig:

    Gold is a passive investment!

  4. johnmoore:

    My mattress bought a new rifle yesterday.

  5. Scott Zorn:

    I've been reading your blog for 5+ years and this is by far my favorite post you've ever written. Everything is completely spot on (not that you needed me to tell you that). Really thankful that somebody else 'gets it.' I started my career with a 'stock-picker,' needless to say the age of quantitative easing hasn't been a boost for relative performance (I saw the writing on the wall and left the firm a long time ago). If I could go back in time, I would've stuck it out. I I very much appreciate you as an economist, an entrepreneur and a writer.

    (Who gives a fuck about an Oxford comma? - vampire weekend)

  6. Dan Wendlick:

    Rational ignorance is rational when you don't have enough cash on hand to move the market. My entire retirement savings, for example, is less than rounding error in Apple or GM's market cap. Whether I own it passively or actively is not going to mater to the share price, and going passive raises the effective return.

  7. Aggie -:

    Well that's not very passive of you.

  8. marque2:

    Part of the activity is in the indexes themselves. the SP500 changes every year, while people at SP add stocks that represent the market better, and remove stocks in serious decline. Same thing happens with the DOW 30 Industrials, evaluations are constantly made, companies doing really poorly are dumped, and companies that "represent the current economy" basically those doing well are added in. It is just not as frequent since there are only 30 stocks.

    You might be getting some of the active management through these index fund managers.

  9. marque2:

    Unless you are actively searching for it, like Yukon Cornelius.

  10. irandom419:

    The best actively managed fund in my 401K is usually about 1% below the SP500 plus fees for that privilege. When I played the stock market it was make $500, then lose $500 and in the end my total take was pretty much $0.

  11. aphofer:

    I didn't react to the earlier post, but here's a few cents worth:

    It's important that you not extend this logic to bond managers, as the majority outperform, and many do so with high persistence (full disclosure, I run a five star bond fund). But the empirics behind passive stock investing are overwhelming. Notice, also, that bond managers generally charge less.

    Despite the obvious logic, I can't buy indexes. In my world, if a company issues more debt, it becomes a bigger part of the index. That makes zero sense. In equity world, if the stock is worth more because it is a) more expensive or b) earned more, it is a bigger part of the index. The latter reason is OK, the former is anathema to me.

    Whether the growth of passive investing makes active investing more or less likely to outperform is an area of intense debate. But it is not a good world where you can do a splashy IPO of something worthless, and indexes just keep buying it. Which is related to your point above.

    A less disturbing outcome - flows will determine everything. Your investment will go up when people are buying and crater when they liquidate. Also, liquidity may suffer, inasmuch as there are fewer contrarians around to make a market for you. So index funds may end up increasing tracking error because some of their holdings can't be sold.

  12. Heresiarch:

    FYI, the well-known investor Howard Marks, famous for his memos, recently came out with one which included a passage about that exact problem:

    The trend toward passive investing has made great strides. Roughly 35% of all U.S. equity investing is estimated to
    be done on a passive basis today, leaving 65% for active management. However, Raj Mahajan of Goldman Sachs estimates that already a substantial majority of daily trading is originated by quantitative and systematic strategies including passive vehicles,
    quantitative/algorithmic funds and electronic market makers. In other words, just a fraction of trades have what Raj calls “originating
    decision makers” that are human beings making fundamental value judgments regarding companies and their stocks, and performing “price discovery” (that is, implementing their views of what something’s worth through discretionary purchases and sales).

    What percentage of assets has to be actively managed by investors driven by fundamentals and value for stocks to be priced “right,” market weightings to be reasonable and passive investing to be sensible? I don’t think there’s a way to know, but people say it can be as little as 20%. If that’s true, active, fundamentally driven investing will determine stock prices for a long time to come. But what if it takes more?

    Passive investing is done in vehicles that make no judgments about the soundness of companies and the fairness of prices. More than $1 billion is flowing daily to “passive managers” (there’s an oxymoron for you) who buy regardless of price. I’ve always viewed index funds as “freeloaders” who make use of the consensus decisions of active investors for free. How comfortable can investors be these days, now that fewer and fewer active decisions are being made?

    Certainly the process described above can introduce distortions. At the simplest level, if all equity capital flows into index funds for their dependability and low cost, then the stocks in the indices will be expensive relative to those outside them. That will create widespread opportunities for active managers to find bargains among the latter. Today, with the proliferation of ETFs and their emphasis on the scalable market leaders, the FAANGs are a good example of insiders that are flying high, at least partially on the strength of non-discretionary buying.

    I’m not saying the passive investing process is faulty, just that it deserves more scrutiny than it’s getting today.