The Context.

Over the past few days, I’ve been getting into debates on Twitter about the boom in Passive Investing. Yes, I’m a nerd. So, I thought I’ll put some structure around this topic. And I believe this structure will help you as you navigate investing.

Recall that Passive Investing is synonymous with Indexing, which means putting money in a low-cost index ETF like the SPDR (based on the S&P 500 Index) instead of Mutual Funds. This movement has gained a lot of traction for 2 main reasons:

1. They’re low-cost, meaning we don’t deal with the ridiculous fees charged by “Active” Managers (Mutual Funds). Fees suck the life out of returns.
2. A majority of Active Managers, especially in the Large-Cap Equity space underperform their benchmark (like the S&P 500) over the long-term.

The first reason is a fact. I mean, fees are a tax on returns. If a manager charges you 1% of your portfolio as fees every year, he/she must outperform the benchmark by at least 1% to justify her keep. Reason #2 says that this sort of outperformance doesn’t happen that often. So, it’s hard to pick a manager that will actually outperform the benchmark in the future to justify the fees. Odds are against you. The best course of action, then, is to put your money in a low-cost index fund like SPDR. You get index-like returns (slightly lower than index) with low fees. Easy.

I have no issues with this. But I’m an active investor because over the long-term I want to maximize my returns. And I want to be invested in the right themes – something I can’t control with an Indexing strategy. However, for most investors who don’t want to think about investing, Indexing is the way to go.

But Passive Investing has developed this aura of “invincibility” that I think is largely misplaced. That’s because I don’t think Passive Investing is that Passive.

I’ll get into why Active Managers underperform, followed by why Passive ain’t so Passive.

Why do Active Managers underperform?

To explain this, there are 2 main arguments thrown around:

1. The market is so efficient that it can’t be beaten.
2. The Institutional Imperative: the business model of the mutual fund industry makes fund managers do stupid things.

In my view, #2 is the biggest reason. As for #1, the markets are efficient over the long run, but there are plenty of dislocations in the short run. As Buffett says:

"Market price and intrinsic value often follow very different paths – sometimes for extended periods – but eventually they meet."

You can also check out The Buylyst Mental Model on Market Efficiency. Our views on this topic are based on what the Giants of Investing have taught us.

Back to #2, I think Buffett (again) captures the essence of the problem. And then Charlie Munger ties a nice bow around it:

“Most managers,” Buffett has said, “have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious; if an unconventional decision works out well, they get a pat on the back, and if it works out poorly, they get a pink slip. Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.” – from the Warren Buffett Way by Robert Hagstrom.

“In Investment Management today, everybody wants not only to win, but to have the path never diverge very much from a standard path except on the upside. Well, that is a very artificial, crazy construct…It’s the equivalent of what Nietzsche meant when he criticized the man who had a lame leg and was proud of it. That is really hobbling yourself. Now, investment managers would say, “We have to be that way. That’s how we’re measured.” And they may be right in terms of the way the business is now constructed. But from the viewpoint of a rational consumer, the whole system’s bonkers and draws a lot of talented people into a socially useless activity.” – Charlie Munger

To summarize, the incentives are not aligned with long-term outperformance. To do that, you have to take risks like deviating significantly from the market in opinion and in allocation decision. Mutual Fund managers tend to play it too safe and hug the benchmark they’re supposed to beat, so they don’t lose their jobs. So, most of them don’t end up beating the benchmark, net of fees. This has been a problem for a long time. And since John Bogle created the low-cost Index Fund at Vanguard, Mutual Fund Managers have had to sharpen their game. Some have, most haven’t.

Now, I don’t have a list of studies that prove the average Fund Manager’s incompetence. I’m assuming they are legit, because that’s what the talking heads keep screaming – “Mutual Funds don’t beat their benchmark!” That may be true – I won’t argue with them. But here’s the point I want to make: They get measured over the long term AND the short term. The proof is in the pudding. They either beat the index, or they don’t.

But…

…some others in the Financial Industry – some of the most vocal supporters of Passive Investing don’t measure themselves to anything concrete.

Passive Investing is not Passive.

There are Robo-Advisors cropping up everywhere. Betterment and Wealthfront led the movement. I like what they do – charge low fees and automate investing in low-cost index funds. They sell convenience. That’s good. But what they also sell is an “Asset Allocation Model”. This is the problem, in my view.

Advisors will ask you to provide them a “Required Rate of Return” over the long-term, and a “Risk Tolerance”. And then they will tailor a portfolio by diversifying across several asset classes to “maximize the chances of achieving that long-term required rate of return”.

I have a problem with that long-term benchmark. What if their asset allocation model doesn’t achieve my required rate of return after 20 or 30 years? Who’s accountable? Does the seller of that Asset Allocation model get as chastised as those Active Mutual Fund Managers? It seems to me that many Advisors escape this accountability, while touting the low-cost merits of Index Funds. Many of them will claim to have saved you money because they put your money in low-cost funds, with low fees. But I can do that myself. Then they’ll claim to give you a “diversified model” of various (presumably) index funds. This is where I have questions.

Here’s the thing: I’d rather have an expensive asset allocation model that guarantees my Required Rate of Return rather than a low-cost model that makes vague claims about Expected Shortfall and Likelihood. And if they claim to be based on the “Modern Portfolio Theory”, then I recommend avoiding them at all costs. The point is: Cost is just one part of the equation. Returns are the main part of the equation. The quality of the asset allocation model drives returns.

There are 2 layers of “asset allocation” decisions in any product that a Robo-Advisor or a Financial Advisor offers you:

1. Allocation among Funds – Passive or Active.
2. Allocation among Asset Classes – Equities, Bonds, Commodities etc.

For now, we’ve conceded that in layer 1, we’ll go with index funds to save fees, which will ultimately compound towards higher returns compared to your average Mutual Fund. But what about layer 2? What model are we using? Does it work?

To answer the second question, Advisors may show you a track record of how this has worked in the past 10, 20, 30 years. And they may show you a “simulation” of how they will work in the future. Here’s the BIG assumption in that marketing pitch: Asset Classes – stocks, bonds, real estate etc. – behave like natural laws, meaning that past return and risk characteristics will repeat in the future. I take issue with this. They’re not natural laws. There is no guarantee that just because US stocks returned 8% annually over the past 50 years, that they will do the same over the next 50.

BUT…

Let’s not fight. Let’s assume they do. Let’s assume that US Stocks or International Stocks or Bonds will return the same X% over the next 20, 30, 40, 50 years as they did over the last 20, 30, 40, 50 years. Let’s take US stocks – the S&P 500. Let’s say that it will return 8% per annum over the next 30 years. IF that’s true, it’s easy for me to achieve. I can buy a low cost SPDR ETF with a few clicks. I can put all my money in that. Why would I do that?

Because it’s easy. And I’m removing ALL layers of Active Asset Allocation decisions – both layer 1 and layer 2. Simple. No Hassle. No "Active-ness" at all.

What am I proposing?

Just as Active Mutual Fund managers (and sometimes Hedge Funds who find creative ways to escape this) are judged on their outperformance against a benchmark, Robo-Advisors and Financial Advisors should be held to an objective, quantitative report card as well. I’m not willing to wait 30 years to judge whether their state-of-the-art asset allocation model worked or didn’t work. How would I judge that?

I will hold the SPDR returns as my benchmark. Why? Because it’s my easiest, most hassle free, completely passive investment vehicle. Unless an Advisor can convince me that his/her diversified portfolio can beat that, why would I pay him/her an extra layer of fees? I don’t want a 6% return with low standard deviation. I don’t care about Sharpe Ratios. Why would I sacrifice 2% a year for a better-looking chart that’s less jagged? I’ll be left with less money and a prettier chart of how it compounded over time. I’ll take the higher returns instead.

This is when I hear murmurs of RISK. People will say “ah but what about volatility?”. This is a flawed argument. 2 reasons:

1. If we believe that asset classes behave like natural laws, I don’t care about volatility in in the long-run. Let me ask you – that if you knew these numbers will hold, which would you choose?
   1. 8% annualized return, with 15% standard deviation?
   2. 6% annualized return, with 12% standard deviation?
   3. Hint: You can’t eat with Sharpe Ratios.
2. Volatility is a short-term measure. It works for traders. It doesn’t work for investors.

Here’s Buffett on volatility and Risk:

Buffett thinks the whole idea that price volatility as a measure of risk is nonsense. In his mind, business risk is reduced, if not eliminated, by focusing on companies with consistent and predictable earnings. “I put a heavy weight on certainty,” he says. “If you do that, the whole idea of a risk factor doesn’t make sense to me. Risk comes from not knowing what you’re doing."

“The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period.”

IF I’m in it for the long-term, and IF I believe that the SPDR will return 8% in the next 30 years because it has returned 8% in the last 30 (the natural law assumption), then I’ll need an advisor to beat the SPDR. 

Of course, I don’t believe it’s a natural law that any asset class will repeat historical returns. That’s a statistical assumption, not based on much economics. If that’s the case, and if I’m right that it’s hard to predict what the SPDR will return over the next 30 years, then the Advisors’ asset allocation models have a bigger problem. They’re trying to drive your portfolio forward using the rear-view mirror.

So, the question is: do you believe that asset classes – like stocks, bonds, commodities, etc. – will behave like natural, scientific laws or not?

If yes, then I propose that the Advisor should beat the SPDR.

If no, then you can’t have much faith in their statistical models of asset allocation. In other words, it’ll be a leap of faith on your part that their statistical analysis is good at estimating future returns.

I’m in the latter group. I’m much better off analyzing companies at a micro level using common-sense and rudimentary algebra rather than analyzing indexes and asset classes at a macro level using fancy statistical models with flawed measures of Risk best used in natural sciences like Physics. Long sentence, sorry. Howard Marks is more eloquent:

“I’m firmly convinced that (a) it’s hard to know what the macro future holds and (b) few people possess superior knowledge of these matters that can regularly be turned into an investing advantage. There are two caveats, however: 1) The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage. 2) With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies. Thus, I suggest people try to ‘know the knowable’.”

It’s time to see through the BS, whether a manager is Active, Passive or somewhere in the middle. I have nothing against Robo-Advisors or Human Advisors as long as they’re honest. Many Human Advisors, I’m sure, are competent and level-headed. I've interacted with a few of them. And they’re the ones to pick. I hope this article helps you ask the right questions.