You can’t beat the average, if you are the average!
Unfortunately, there are many people in the wealth management industry who do not understand that it’s impossible for active managers to outperform—as a whole. I believe the foremost reason is that most don’t understand how a market works. Folks forget the financial market is just that—a market. How many countless studies and reports have you seen on the active vs. passive debate? How many hours were wasted conducting and reading such research? How many incorrect conclusions were drawn? In the following paragraphs, let’s examine why passive management will always outperform active management, and it is as straightforward as 1 + 1 = 2.
Establishing how markets work:
Markets are a regular gathering of people for the purchase and sale of something. The transactions conducted must be voluntary; hence, a free market. Each of the participants must assign a different value to what is being exchanged; otherwise, there is no transaction. Whatever is sold on the market has to be owned by someone. Now, let’s start with a simple example of a barter market for apples and oranges. Let’s assume there are four participants in this barter market and they have grown 50 units of each fruit. The market will have a fixed number of apples and oranges—200 of each. When the market opens, the participants will have to meet and decide how many of each fruit they want. All the buyers/sellers have an active preference that is displayed by their willingness to exchange apples and oranges. If they don’t have a preference, they will just keep the 50 apples and 50 oranges they have grown.
For example, each can have the following preference:
- Participant 1: wants 40 apples, and 60 oranges → gives up 10 apples for 10 oranges
- Participant 2: wants 80 apples, and 20 oranges → gives up 30 oranges for 30 apples
- Participant 3: wants 60 apples, and 40 oranges → gives up 10 oranges for 10 apples
- Participant 4: wants 20 apples, and 80 oranges → gives up 30 apples for 30 oranges
Has the total market changed after the transactions?
No, only the allocation of apples and oranges between participants has changed. Some prefer apples (Participants 2 & 3), so they have overweighted their allocation to apples. The reverse goes for Participants 1 & 4.
What is the average allocation to apples? To oranges?
The average (aka passive) allocation remains 50 of each—200 apples/4 participants.
Well, of course, the average has not changed. We simply shuffled things around based on preferences. How does this apply to securities markets which generate returns?
Let’s look at the equity market now:
We know that there are a certain number of securities in the market, and all those securities are owned by someone. Buyers and sellers enter the market each day and trade based on their beliefs (e.g., assumed mispricings) and needs (e.g., pay for kids’ tuition.) Some buy more of one security and sell another, some sell more of one security and buy another, others increase or decrease their allocation to yet another security, etc. For every buyer, there has to be a seller, since someone has to own the securities at all times. The point is that each participant will overweight and underweight each security based on his or her preference. Notice that each investor’s preference would not change the total market. The preferences are what we call active investing. All the securities that each participant has decided to own will always sum up to the total market.
“There is no such a thing as an unowned security”
What does that mean as far as returns? It means that yes, some of those securities will outperform and some will underperform, but the average performance of the active participants will just be equal to the market performance. This is what is meant by “active management is a zero-sum game.” For every outperformer, there has to be an equal underperformer. For every seller, there has to be a buyer. For every overweight, there has to be an underweight, compared to the overall market. Each weight different from the market capitalization weight is an active weight. The sum of all the active weights will always equal zero. The active participants’ performance as a whole will always equal the market performance. Yes, there are the participants who will beat the market, but only if there are other participants who underperformed by the exact same amount. It’s simple math, with no empirical testing necessary.
By default and simple arithmetic, we proved that:
- The average performance, before any expense, of active market participants will equal the total market performance.
- Stated differently, the active participants within a market do not influence the returns of the total market; they just shuffle these returns among themselves, with an offsetting amount of losers and winners.
You may think that this is an oversimplified example, but capital markets actually work in this manner. Further, IPOs, dividends, etc. do not change these mechanics. Someone has to own the assets at all times and must decide how to allocate among them based on her or his preferences.
Now, let’s establish a few definitions:
- An active investor is someone whose security weights/allocation deviates from the market.
- A passive investor is someone whose security weights/allocation matches the market.
So, what is the goal of passive investing? The goal of passive investing is to replicate the overall market return. To do this, passive investing needs to purchase all the market securities in their proportionate capitalization weights. Hence, passive investors and active investors, in the aggregate, will have the exact same allocation. More bluntly put, passive management is just a copy of all active management valuations/allocations.
“Passive investing is duplicating valuations/preferences established by all the active investors”
So far, so good. We know active managers cannot beat the market before expenses—only match it. We can now move forward and establish why passive investors will outperform active investors. The reasons for this outperformance are costs and fees. To conduct active management, one has to hire someone to manage the investments, carry out research and make expenditures on technology, marketing and selling, etc. Active management is expensive and time-consuming, and you can see that in the difference in fees between the passive and active funds. One can find cap-weighted index funds or ETFs with 0.04 to 0.20 percent expense ratios, compared with 0.70 to 1.20 percent expense ratios for equivalent actively-managed funds (not to even speak of hedge funds.) These are large differences for which the active management investors cannot compensate—particularly once one considers compounding.
Knowing all this we conclude:
- Passive and active investing will produce the same returns, before fees, since they are just two sides of the same coin.
- Active investors, taken as a whole, will underperform passive funds by the difference in fees.
Now let’s look at specific examples and research, the “SPIVA® U.S. Scorecard.” S&P conducts this annual research report to see how active managers are faring against their benchmark. Numerous folks out there draw the wrong conclusions that active managers, as a whole, can outperform on occasions, or that active investing may outperform passive investing (or vice versa) in cycles.
Note snippet below from SPIVA US Scorecard:
Notice that in certain years active managers have supposedly outperformed their “benchmark.” For example, “All Domestic Funds” surpassed the S&P 1500 Composite in 2015. But wait, didn’t we just establish that this is not possible? Here are the problems with such reports and research:
- S&P is using only a portion of the active managers out there (US open-end funds.) The report omits all other investors that also hold securities contained in the index. For instance, all hedge fund managers, sovereign wealth funds, foreign investors, US individual investors, etc., are excluded. Also, we know that some of those groups must have underperformed, not that active managers have automatically beaten their benchmark. As we concluded earlier, it is not arithmetically possible for active managers to surpass their true benchmark/market. Only certain groups can outperform it at the expense of others. This report only shows that US open-end funds did well against other active players in the market.
- The S&P 1500 is not the appropriate benchmark for many of those funds. “All Domestic Funds” hold securities outside the S&P 1500 that will cause their performance to deviate from the index. This can be measured by the active share statistic that has become popular.
The same wrong conclusions can be drawn from “Morningstar Active/Passive Barometer” below:
It would be more appropriate to title such reports as “active open-end funds versus passive open-end funds,” not “active versus passive,” since a huge portion of the active participants are missing. Also, notice that, in the long-term, the numbers smooth out.
Hopefully, this piece illustrated that there is a considerable amount of noise in the industry and many of the so-called “experts” don’t truly understand the passive vs. active debate, and/or they intentionally try to mislead people. It is not really a debate once one understands the market mechanics. Passive investing is a copy of the active investors’ allocations; accordingly, both will produce the same performance before fees. Therefore, passive investing and diversification are the only free lunches one will obtain in the financial markets—use them wisely!
Also, for a separate topic, investing in an S&P 500 index fund or ETF is not truly passive (What entails being passive?).
Special thanks to professor William F. Sharpe, for his short paper on this topic!
“SPIVA US Scorecard”, https://us.spindices.com/search/?ContentType=SPIVA
“Morningstar Passive/Active Barometer”, http://news.morningstar.com/articlenet/article.aspx?id=701736
“The Arithmetic of Active Management” by William F. Sharpe https://web.stanford.edu/~wfsharpe/art/active/active.htm