About Us:
Investment Style
Active vs. Passive Investing
Described
To implement an investment strategy there are
two fundamentally different investment styles, active versus
passive. These two styles are based on very different views of
how capital markets operate.
Active investors seek returns in excess of a
specified benchmark, in short, they attempt to “beat the market.”
Their attempts usually involve stock picking or market timing, or a
combination of the two.
Stock pickers try to exploit perceived market
inefficiencies by searching for advantageous sectors of the market
or for companies that they believe are selling at a discount to
their true economic value. However, data shows that consistently
beating the market is practically impossible. William Bernstein in
his book, The Intelligent Asset Allocator, states the results
of his research on stock picking: "It turns out for all practical
purposes there is no such thing as stock picking skill. It's human
nature to find patterns where there are none and to find skill where
luck is a more likely explanation (particularly if you're the lucky
[mutual fund] manager). Mutual fund manager performance does not
persist and the return of stock picking is zero. We are looking at
the proverbial bunch of chimpanzees throwing darts at the stock
page. Their ‘success’ or ‘failure’ is a purely random affair."
Market timers try to predict when markets will
change directions, in other words they attempt to “buy low and sell
high.” It seems logical that a market timer would only have to be
right 51% of the time to outperform the market, but that is not
true. According to a study by New York University, market timers
must be right about 70% of the time to outperform a passive
investor. Nobel Laureate William Sharpe determined that market
timers “must be right roughly three times out of four…” The SEI
Corporation study put the number at 69%. The problem is not only
that market timers must avoid losses in down markets, but also, they
must catch the unpredictable short and intense bursts of gains at
the beginning of rising markets. The odds against being successful
at this are overwhelming.
Passive investing is the alternative to the
active approach to investing. Passive investors believe it is a
waste of time and money to attempt to find undervalued stocks or to
attempt to exploit short-term fluctuations in markets. Instead of
trying to “beat the market” they use diversification and discipline
to capture the long-term returns of the market. Index mutual funds
and asset class funds are used to capture the returns of different
market segments and long-term patterns of returns are used to
combine these funds into portfolios intended to reduce annual
volatility instead of maximizing annual returns. As it was pointed
out earlier, reducing volatility is a more efficient way to increase
a portfolio’s value then attempting to maximize the annual returns.
Active vs. Passive Investing
Conclusion
While much, if not most, of the money managed
by stockbrokerage firms, trust companies, individual investment
advisors, and others is invested using active investment strategies,
we prefer a passive approach, because we believe it is generally
less risky, less expensive, and less exposed to taxes. Active
investment choices that raise the concentration of assets in a
particular area may increase the degree of diversifiable (excess and
undesirable) risk and more frequent trading generates higher
transaction costs and unfavorable tax results. While active
investing's hope of “beating the market” is appealing,
John Bogle, the founder of Vanguard Funds, concludes that because of
lower costs “passive investing seems the obvious answer.”
Morningstar, the mutual fund rating service, determined that there are
1,446 large-cap blend funds that invest in the similar asset class
of the S&P 500 index. Over the recent 10 year period ending October
2004, only 35
out of 1,446
matched or beat the performance of the S&P 500
index. That is a whopping
2.4%, and that number pretty much goes to zero if
you factor in taxes. Morningstar also looked at the last 3 years,
which has been a very difficult period for the index, and only
22 of the
1,446
consistently beat the S&P 500.
Piscataqua Research Inc., an institutional
think-tank, published findings in the late '90s showing that only 14
out of the 145 largest (and most sophisticated) institutional
investment plans managed to beat a simple (60%/40%) combination of
the S&P 500 Index and long-term bonds.
Merton Miller, Nobel Laureate and Professor of
Economics, Univ. of Chicago, described active investing as follows:
"If there are 10,000 people looking at the stocks and trying to pick
winners, one in 10,000 is going to score, by chance alone, a great
coup, and that's all that's going on. It's a game, it's a chance
operation, and people think they are doing something purposeful...
but they're really not."
Eugene Fama, Jr.
of Dimensional Fund Advisors put it this way: "After taking risk
into account, do more managers than you'd see by chance outperform
with persistence? Virtually every economist who studied this
question answers with a resounding "no." Mike Jensen, in the
Sixties, and Mark Carhart, in the Nineties, both conducted
exhaustive studies of professional investors. They each conclude
that, in general, a manager's fee, and not his skill, plays the
biggest role in performance." In other words, the higher the fee,
the lower the performance.
Active vs. Passive Investing
Summary
Even though we are well aware of the
unpredictability of investment return, we cannot say it is
impossible for an investment advisor to beat the markets. However,
we do feel comfortable in saying there is no way of predicting in
advance who those “winning” advisors will be. History shows that, in
the long run, a thoughtfully designed, diversified strategy of
"passive" funds typically beats all but a few active managers. It's
not easy to structure and maintain such a strategy. It requires
understanding of the academic research and the discipline to stay
the course, but it’s much easier than predicting which active
managers will randomly beat this approach.
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