I was a doctoral student at UCLA, in 1983 and 1984, when I was assigned to be research assistant to Professor Eugene Fama, who wisely abandoned the University of Chicago during the cold winters for the beaches and tennis courts of Southern California. Professor Fama won the Nobel Prize for Economics in 2013, primarily for laying the foundations for efficient markets in this paper and refining them in his work in the decades after. The debate between passive and active investing that he and others at the University of Chicago initiated has been part of the landscape for more than four decades, with passionate advocates on both sides, but even the most ardent promoters of active investing have to admit that passive investing is winning the battle. In fact, the mutual fund industry seems to have realized that they face an existential threat not just to their growth but to their very existence and many of them are responding by cutting fees and offering passive investment choices.
Passive Investing is winning!
When Jack Bogle started the Vanguard 500 Index fund in 1975, I am sure that even he could not have foreseen how successful it would become in changing the way we invest. Not only have index funds become an increasing part of the landscape, but exchange traded funds have also added to the passive investing mix and index-based investing has expanded well beyond the S&P 500 to cover almost every traded asset market in the world. Today, you can put together a portfolio composed of index funds and ETFs to create any market exposure that you want in stocks, bonds or commodities. The growth of passive investing can be seen in the graph below, where I plot the proportion of the US equity market held by passive investors (in the form of ETFs and index funds) and active investors from 2005 to 2016:
When Jack Bogle started the Vanguard 500 Index fund in 1975, I am sure that even he could not have foreseen how successful it would become in changing the way we invest. Not only have index funds become an increasing part of the landscape, but exchange traded funds have also added to the passive investing mix and index-based investing has expanded well beyond the S&P 500 to cover almost every traded asset market in the world. Today, you can put together a portfolio composed of index funds and ETFs to create any market exposure that you want in stocks, bonds or commodities. The growth of passive investing can be seen in the graph below, where I plot the proportion of the US equity market held by passive investors (in the form of ETFs and index funds) and active investors from 2005 to 2016:
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| Source: Morningstar |
In 2016, passive investing accounted for approximately 40% of all institutional money in the equity market, more than doubling its share since 2005. Since 2008, the flight away from active investing has accelerated and the fund flows to active and passive investing during the last decade tell the story.
The question is no longer whether passive investing is growing but how quickly and at what expense to active investing. The answer will have profound consequences not only for our investment choices going forward, but also for the many employed, from portfolio managers to sales people to financial advisors, in the active investing business.
Aided and Abetted by Active Investing
To understand the shift to passive investing and why it has accelerated in recent years, we have to look no further than the investment reports that millions of investors get each year from their brokerage houses or financial advisors, chronicling the damage done to their portfolios during the course of the year by frenetic activity. Put bluntly, investors are more aware than ever before that they are often paying active money managers to lose money for them and that they now have the option to do something about this disservice.
To understand the shift to passive investing and why it has accelerated in recent years, we have to look no further than the investment reports that millions of investors get each year from their brokerage houses or financial advisors, chronicling the damage done to their portfolios during the course of the year by frenetic activity. Put bluntly, investors are more aware than ever before that they are often paying active money managers to lose money for them and that they now have the option to do something about this disservice.
1. Collectively, active investing cannot beat passive investing (ever)!
Before you attack me for being a dyed-in-the-wool efficient marketer, there is a simple mathematical reason why this statement has to be true. During 2015, for instance, about 40% of institutional money in equities was invested in index funds and ETFs and about 60% in active investing of all types. The money invested in index funds and ETFs will track the index, with a very small percentage (about 0.11%) going to cover the minimal transactions costs. Thus, active money managers have to start off with the recognition that they collectively cannot beat the index and that their costs (transactions and management fees) will have to come out of the index returns. Not surprisingly, therefore, active investors will collectively generate less than the index during every period and more than half of them will usually underperform the index. To back up the first statement, here are the median returns for all actively managed funds, relative to passive index funds for various time periods ending in 2015:
Before you attack me for being a dyed-in-the-wool efficient marketer, there is a simple mathematical reason why this statement has to be true. During 2015, for instance, about 40% of institutional money in equities was invested in index funds and ETFs and about 60% in active investing of all types. The money invested in index funds and ETFs will track the index, with a very small percentage (about 0.11%) going to cover the minimal transactions costs. Thus, active money managers have to start off with the recognition that they collectively cannot beat the index and that their costs (transactions and management fees) will have to come out of the index returns. Not surprisingly, therefore, active investors will collectively generate less than the index during every period and more than half of them will usually underperform the index. To back up the first statement, here are the median returns for all actively managed funds, relative to passive index funds for various time periods ending in 2015:
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| Source: S&P (SPIVA) |
The median active equity fund manager underperformed the index by about 1.21% a year between 2006 and 2015 and by far larger amounts over one-year (-2.92%), three year (-2.78%) and five year (-2.90%). Thus, it should come as no surprise that well over half of all active fund managers have been outperformed by the index over different time periods:
Note that in this graph, active fund managers in equity, bond and real estate all under perform their passive counterparts, suggesting that poor performance is not restricted just to equity markets.
If active money managers cannot beat the market, by construct, how do you explain the few studies that claims to find that they do? There are three possibilities. The first is that they look at subsets of active investors (perhaps hedge funds or professional money managers) rather than all active investors and find that these subsets win, at the expense of other subsets of active investors. The second is that they compare the returns generated by mutual funds to the return on a stock index during the period, a comparison that will yield the not-surprising result that active money managers, who tend to hold some of their portfolios in cash, earn higher returns than the index in down markets, entirely because of their cash holdings. You can perhaps use this as evidence that mutual fund managers are good at market timing, but only if they can generate excess returns over long periods. The third is that these studies are comparing returns earned by active investors to a market index that might not reflect the investment choices made by the investors. Thus, comparing small cap active investors to the S&P 500 or global investors to the MSCI may reveal more about the limitations of the index than it does about active investing.
2. No sub-group of active investors seems to be able to beat the market
The standard defense that most active investors would offer to the critique that they collectively underperform the market is that the collective includes a lot of sub-standard active investors. I have spent a lifetime talking to active investors who contend that the group (hedge funds, value investors, Buffett followers) that they belong to is not part of the collective and that it is the other, less enlightened groups that are responsible for the sorry state of active investing. In fact, they are quick to point to evidence often unearthed by academics looking at past data that stocks with specific characteristics (low PE, low Price to book, high dividend yield or price/earnings momentum) have beaten the market (by generating returns higher than what you would expect on a risk-adjusted basis). Even if you conclude that these findings are right, and they are debatable, you cannot use them to defend active investing, since you can create passive investing vehicles (index funds of just low PE stocks or PBV stocks) that will deliver those excess returns at minimal costs. The question then becomes whether active investing with any investment style beats a passive counterpart with the same style. SPIVA, S&P’s excellent data service for chronicling the successes and failures of active investing, looks at the excess returns and the percent of active investors who fail to beat the index, broken down by style sub-group.
The standard defense that most active investors would offer to the critique that they collectively underperform the market is that the collective includes a lot of sub-standard active investors. I have spent a lifetime talking to active investors who contend that the group (hedge funds, value investors, Buffett followers) that they belong to is not part of the collective and that it is the other, less enlightened groups that are responsible for the sorry state of active investing. In fact, they are quick to point to evidence often unearthed by academics looking at past data that stocks with specific characteristics (low PE, low Price to book, high dividend yield or price/earnings momentum) have beaten the market (by generating returns higher than what you would expect on a risk-adjusted basis). Even if you conclude that these findings are right, and they are debatable, you cannot use them to defend active investing, since you can create passive investing vehicles (index funds of just low PE stocks or PBV stocks) that will deliver those excess returns at minimal costs. The question then becomes whether active investing with any investment style beats a passive counterpart with the same style. SPIVA, S&P’s excellent data service for chronicling the successes and failures of active investing, looks at the excess returns and the percent of active investors who fail to beat the index, broken down by style sub-group.
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| Source: S&P (SPIVA) |
Note that not only is there not a single sub-group that has been able to beat the index for that group but also that the magnitude of under performance is staggering. It is true that these are the results for US equity fund managers, but just in case you are holding out hope that active money management is better at delivering results in other markets, the following table that looks at the percent of active managers who fail to beat indices in their markets should cast doubt on that claim:
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| Source: S&P (SPIVA) |
There are glimmers of hope in the one-year returns in Europe and Japan and in the emerging markets, but there is not a single geography where active money managers have beaten the index over the last five years.
3. Consistent winners are rare
The third and final line of defense for active investors is that while they collectively underperform and that underperformance stretches across sub-groups, there is a subset of consistent winners who have found the magic ingredient for investment success. That last hope is dashed, though, when you look at the numbers. If there is consistent performance, you should see continuity in performance, with highly ranked funds staying highly ranked and poor performers staying poor. To see if that is the case, I looked at how portfolio managers ranked by quartile in one period did in the following three years:
The third and final line of defense for active investors is that while they collectively underperform and that underperformance stretches across sub-groups, there is a subset of consistent winners who have found the magic ingredient for investment success. That last hope is dashed, though, when you look at the numbers. If there is consistent performance, you should see continuity in performance, with highly ranked funds staying highly ranked and poor performers staying poor. To see if that is the case, I looked at how portfolio managers ranked by quartile in one period did in the following three years:
Note that the numbers in the table, when you look at all US equity funds, suggest very little continuity in the process. In fact, the only number that is different from 25% (albeit only marginally significant on a statistical basis) is that transition from the first to the fourth quartile, with a higher incidence of movement across these two quartiles than any other two. That should not be surprising since managers who adopt the riskiest strategies will spend their time bouncing between the top and the bottom quartiles.
As your final defense of active investing, you may roll out a few legendary names, with Warren Buffett, Peter Lynch and the latest superstar manager in the news leading the list, but recognize that this is more an admission of the weakness of your argument than of its strength. In fact, successful though these investors have been, it becomes impossible to separate how much of their success has come from their investment philosophies, the periods of time when they operated and perhaps even luck. Again, drawing on the data, here is what Morningstar reports on the returns generated by their top mutual fund performer each year in the subsequent two years:
While the numbers in 2000 and 2001 look good, the years since have not been kind to super performers who return to earth quickly in the subsequent years. We could try to explain the failure of active investing to deliver consistent returns over time with lots of reasons, starting with the investment world getting flatter, as more investors have access to data and models but I will leave that for another post. Suffice to say, no matter what the reasons, active investing, as structured today, is an awful business, with little to show for all the resources that are poured into it. In fact, given how much value is destroyed in this business, the surprise is not that passive investing has encroached on its territory but that active investing stays standing as a viable business.
The What next?
Since it is no longer debatable that passive investing is winning the battle for investor money, and for good reasons, the question then becomes what the consequences will be. The immediate effects are predictable and painful for active money managers.
Since it is no longer debatable that passive investing is winning the battle for investor money, and for good reasons, the question then becomes what the consequences will be. The immediate effects are predictable and painful for active money managers.
- The active investing business will shrink: The fees charged for active money management will continue to decline, as they try to hold on to their remaining customers, generally older and more set in their ways. Notwithstanding these fee cuts, active money managers will continue to lose market share to ETFs and index funds as it becomes easier and easier to trade these options. The business will collectively be less profitable and hire fewer people as analysts, portfolio managers and support staff. If the last few decades are any indication, there will be periods where active money management will look like it is mounting a comeback but those will be intermittent.
- More disruption is coming: In a post on disruption, I noted that the businesses that are most ripe for disruption are ones where the business is big (in terms of dollars spent), the value added is small relative to the costs of running the business and where everyone involved (businesses and customers) is unhappy with the status quo. That description fits the active money management like a glove and it should come as no surprise that the next wave of disruption is coming from fintech companies that see opportunity in almost every facet of active money management, from financial advisory services to trading to portfolio management.
While active investing has contributed to its own downfall, there is a dark side to the growth of passive investing and many in the active money management community have been quick to point to some of these.
- Corporate Governance: As ETFs and index funds increasing dominate the investment landscape, the question of who will bear the burden of corporate governance at companies has risen to the surface. After all, passive investors have no incentive to challenge incumbent management at individual companies nor the capacity to do so, given their vast number of holdings. As evidence, the critics of passive investors point to the fact that Vanguard and Blackrock vote with management more than 90% of the time. I would be more sympathetic to this argument if the big active mutual fund families had been shareholder advocates in the first place, but their track record of voting with management has historically been just as bad as that of the passive investors.
- Information Efficiency: To the extent that active investors collect and process information, trying to find market mistakes, they play a role in keeping prices informative. This is the point that was being made, perhaps not artfully, by the Bernstein piece on how passive investing is worse than Marxism and will lead us to serfdom. I wish that they had fully digested the Grossman and Stiglitz paper that they quote, because the paper plays out this process to its logical limit. In summary, it concludes that if everyone believes that markets are efficient and invests accordingly (in index funds), markets would cease to be efficient because no one would be collecting information. Depressing, right? But Grossman and Stiglitz also used the key word (Impossibility) in the title, since as they noted, the process is self-correcting. If passive investing does grow to the point where prices are not informationally efficient, the payoff to active investing will rise to attract more of it. Rather than the Bataan death march to an arid information-free market monopolized by passive investing, what I see is a market where active investing will ebb and flow over time.
- Product Markets: There are some who argue that the growth of passive investing is reducing product market competition, increasing prices for customers, and they give two reasons. The first is that passive investors steer their money to the largest market cap companies and as a consequence, these companies can only get bigger. The second is that when two or more large companies in a sector are owned mostly by the same passive investors (say Blackrock and Vanguard), it is suggested that they are more likely to collude to maximize the collective profits to the owners. As evidence, they point to studies of the banking and airline businesses, which seem to find a correlation between passive investing and higher prices for consumers. I am not persuaded or even convinced about either of these effects, since having a lot of passive investors does not seem to provide protection against the rapid meltdown of value that you still sometimes observe at large market cap companies and most management teams that I interact with are blissfully unaware of which institutional investors hold their shares.
The rise of passive investing is an existential threat to active investing but it is also an opportunity for the profession to look inward and think about the practices that have brought it into crisis. I think that a long over-due shakeup is coming to the active investing business but that there will be a subset of active investors who will come out of this shakeup as winners. As to what will make them winners, I have to hold off until another post.
Making it personal
Should you be an active investor or are you better off putting your money in index funds? The answer will depend on not only what you bring to the investment table in the resources but also on your personal make-up. I have long argued that there is no one investment philosophy that works for all investors but there is one that is just right for you, as an investor. In keeping with this philosophy of personalized investing, I think it behooves each of us, no matter how limited our investment experience, to try to address this question. To start this process, I will make the case for why I am an active investor, though I don’t think any you will or should care. I will begin by listing all the reasons that I will not give for investing actively. Since I use public information in financial statements and databases, my information is no better than anyone else’s. While my ego would like to push me towards believing that I can value companies better than others, that is a delusion that I gave up on a long time ago and it is one reason that I have always shared my valuation models with anyone who wants to use them. There is no secret ingredient or special sauce in them and anyone with a minimal modeling capacity, basic valuation knowledge and common sense can build similar models.
Should you be an active investor or are you better off putting your money in index funds? The answer will depend on not only what you bring to the investment table in the resources but also on your personal make-up. I have long argued that there is no one investment philosophy that works for all investors but there is one that is just right for you, as an investor. In keeping with this philosophy of personalized investing, I think it behooves each of us, no matter how limited our investment experience, to try to address this question. To start this process, I will make the case for why I am an active investor, though I don’t think any you will or should care. I will begin by listing all the reasons that I will not give for investing actively. Since I use public information in financial statements and databases, my information is no better than anyone else’s. While my ego would like to push me towards believing that I can value companies better than others, that is a delusion that I gave up on a long time ago and it is one reason that I have always shared my valuation models with anyone who wants to use them. There is no secret ingredient or special sauce in them and anyone with a minimal modeling capacity, basic valuation knowledge and common sense can build similar models.
So, why do I invest actively? First, I am lucky enough to be investing my own money, giving me a client who I understand and know. It is one of the strongest advantages that I have over a portfolio manager who manages other people’s money. Second, I have often described investing as an act of faith, faith in my capacity to value companies and faith that market prices will adjust to that value. I would like to believe that I have that faith, though it is constantly tested by adverse market movements. That said, I am not righteous, expecting to be rewarded for doing my homework or trusting in value. In fact, I have made peace with the possibility that at the end of my investing life, I could look back at the returns that I have made over my active investing lifetime and conclude that I could have done as well or better, investing in index funds. If that happens, I will not view the time that I spend analyzing and picking stocks as wasted since I have gained so much joy from the process. In short, if you don’t like markets and don’t enjoy the process of investing, my advice is that you put your money in index funds and spend your time on things that you truly enjoy doing!
YouTube Video
YouTube Video
Professor Damodaran,
ReplyDeleteI am an avid follower of your courses, blogs, books etc. I appreciate everything you do for the investing community and I would like to thank you.
On the topic of passive investing, I was wondering what your opinion is on the "Graham Defensive Investor" style of passive investing. With stock market valuations rather high, could it make sense to adopt such a strategy as an alternative to indexing? The goal would not be to "beat the market", rather to get higher risk adjusted returns, investing in stocks that have lower p/e and b/v ratios, with his minimum criteria for growth.
Thanks,
Bryan
Hi Brian,
DeleteI'm now rereading the intelligent investors and the chapter on defensive investors talks about these criteria: 1 yr pe<20, avg 5 yr pe < 25,large and prominent companies, long history of dividend, diversification of at the most 30 stocks. Graham's other part of the portfolio is high grade bonds. My comment on this is as follows: if you have a certain asset allocation between investment grade bond etf and a stock etf and provided that you rebalance once the stock part gets high (high pe), you will tick all Graham's recommendations. Because normally sp500 aggregate pe is not higher than 20 (I think).
Prof. Damodaran,
ReplyDeleteI feel like I am missing something in the demonstration for your first argument. You say "The money invested in index funds and ETFs will track the index, with a very small percentage (about 0.11%) going to cover the minimal transactions costs. Thus, active money managers have to start off with the recognition that they collectively cannot beat the index and that their costs (transactions and management fees) will have to come out of the index returns."
How is that a proof? I don't see the argument here, what am I missing?
Dear Prof,
ReplyDeleteThank you for taking a view that is contrary to your own style of investing as this is something seldom observed in the industry. However, I am not able to digest the part on the efficient capital markets. If passive investing tends to create an information free market necessitating active investing then the two shall always coexist on a continuous time scale instead of the ebb and flow that you mention. It's just that they will perhaps stabilize at an equilibrium point as dictated by economics that super-normal profits(returns) cannot exist for long. Would love to know your views on what can this equilibrium be and what factors will influence this equilibrium.
Regards,
Curious
Ric,
ReplyDeleteLet's say there are 100 investors in the market, 40 are passive and 60 are active. Let's say the market generates a 10% return. The passive investors mimic the market and will generate close to 10%; net of transactions costs, let's say 9.90%. The remaining 60 investors cannot earn more than 10% collectively, and they too will earn 10% less their transactions costs which will be higher. Thus, by construct, active investors collectively cannot beat the market.
As for the second point, I think I agree with you on the basic point that passive and active investing will co-exist. My point is that you don't need as much active investing as you see today, i.e., a 20% active, 80% passive might deliver what you want but you will see the market over shoot and under shoot this optimal.
Professor Damodaran -
ReplyDeleteI'm also missing this point. Why can't the 60% active earn more than 10%? Don't we see value-driven hedge funds and professional managers beating the S&P500 in many instances?
I think that you are missing the word "collectively". A subset of active investors may win but if it does, it has to come at the expense of other active investors. However, even that faint hope that value investors or deep value investors beat the market, is shattered when you look at the excess returns by subset.
ReplyDeleteDear professor, thank you for another interesting post.
ReplyDeleteOne question: do your data also support the view that passive investment is more attractive than active investment on a risk-adjusted basis? in other words, if we use a measure of risk such as the volatility of returns or the drawdown over a given number of years (or other measures), do you still have that passive investment outperforms active investment? Could the underperformance of active investment be related to a lower risk level (measured with some of the usual ratios: Sharpe, Information Ratio, Calmar...)?
Thanks and best regards, Frank
Dear Professor Damodaran
ReplyDeleteFirst of all I wanted to say that I am a big fan of your writing. I am posting today because I take issue with how you distinguish between active and passive investing.
As I understand it, the only true passive equity strategy is owning all the stocks in the opportunity set prorated by size (market index portfolio). The more one deviates from the market portfolio, the more active the strategy. If we limit our opportunity set to the US equity market, then investing in an ETF covering the Russell 3000 (~98% of US mkt cap) is the closest one can get to a true passive strategy, as it’s the only buy and hold portfolio that all the participants in the market can hold in equilibrium.
Investing in the S&P 500 (~70% of US mkt cap) is the same as making an explicit bet on larger cap stocks that will periodically under/outperform the Russell 3000 over time. If more and more people in the market started piling their money into the S&P 500, smaller cap stocks, starved for capital, would become increasingly attractive from a risk/return perspective. Same goes for Smart Beta ETFs that attempt to beat the market by buying more of some stocks and less of others relative to the index based on a handful of idiosyncratic factor exposures. But under your active/passive chart groupings, S&P500 and fundamental ETFs would both be considered passive investment strategies.
I think the real story the finance press misses--one revealed by a more granular decomposition of the numbers--is the rise of more machine augmented-active investing. To put it another way, I believe the current generation smart-beta ETFs, representing an increasing share of ETF growth, are active strategies that will continue to evolve, giving way to smart beta 2.0 ETFs that exploit more powerful big data methodologies and advancements in financial theory.
Few thoughts:
ReplyDelete1) The Passive-S&P-500 Bubble
While 40% of money are in passive funds, I wonder how much are specifically invested in S&P 500 Index funds? Wild call here: I think a S&P-500 bubble will be created if half of the institutional money are invested in the S&P-500 funds.
First of all, passive investors don't analyze, they just follow the queue from S&P (however S&P want to set the index). Lazy and irrational.
Secondly, the "automated" investing process in the market-cap-weighted S&P 500 Index -- the stocks that are likely to be overvalued get largest chunk of the money, vice versa -- is a self-defeating investment process. Whenever a billionaire pumps in $100m into a S&P-500 fund, the stocks of Apple and Microsoft will shoot up for no fundamental reason while First Solar and News Corp will get the least benefits from the fund inflow.
If this process goes on indefinitely, problems will come. It will eventually come to a point when company executives will always try to lobby S&P for inclusion to the index.
2) Size does matter
It doesn't make any more sense for BlackRock, Vangard, State Street, Fidelity, etc. to go for active management. They are THE market, so why try to outperform yourself?
Same goes to the clients. If you have tens of billions to invest, trying to outperform the overall market is nonsense. Just stick to index funds and it will save you a lot of costs and unproductive efforts.
But if you have just thousands or millions to invest, finding a small value-oriented active fund manager is the way to go. DON'T INVEST IN BIG SIZE ACTIVE FUNDS. Big funds are forced to buy Amazon/Apple/Alphabet/FB/Wells Fargo/JP Morgan whenever they get fund inflow, they are the de facto passive investors! Smaller funds may still be able to OCCASIONALLY find values in the market and be able to invest for a significant weightage in the portfolio. Outperforming managers are rare, but they are small and they are out there.
It is called "The Beauty of Being Small".
3) Conclusion: Don't write-off active management, especially the smaller ones. Selecting good active funds require skills too, just like stockpicking. Investing in passive funds is for large and/or lazy guys.
Blogger Peter S. said...
ReplyDeleteProfessor Damodaran -
I'm also missing this point. Why can't the 60% active earn more than 10%? Don't we see value-driven hedge funds and professional managers beating the S&P500 in many instances?
Perhaps I can break it down more simply:
If the market earns 10%, by definition it means that as a whole, all the market participants - both active and passive investors- would have earned 10% less their respective expenses.
Let's leave expenses out for now.
As a group, the passive investors would have made the market return so they would have made roughly 10%.
As a group, the active investors cannot have made more than 10%. For them to have made more than 10%, the passive investors would have had to make less than 10% so that the market average would still be 10%. Since we know the market made 10%, and the passive group made 10%, the active group must also have made 10%. Some within the active group would have made 12%, 15%, 22%; others within the active group would have made 8%, 5%, -2%...that's how it is with active investing. But as a group they would have made 10%.
Now let's bring expenses into it.
Assuming passive investing expenses are 0.11%, then the passive group would have made returns of 10% - 0.11% = 9.89%.
Assuming active investing expenses are 2% (some may be more, some may be less, but certainly none will be less than the passive investing expenses because of management fees and higher trading costs etc), then the active group would have made 10% - 2% = 8% on average.
So yes, due to expenses, active investors collectively cannot beat passive investors. The key word, as Prof Damodaran pointed out, is collectively.
Best,
Sean C
I'm puzzled. Surely you understand that value investing isn't anywhere near as simple as a low multiple (P/E, P/B, etc.) heuristic? To illustrate, a fantastic company with a high probability of massively compounding its earnings over the next decade may be a phenomenal value investment at 40x earnings (eg. Google, Facebook, Visa, many more).
ReplyDeleteAn alternative view- I hope you and other readers will call out any holes in my reasoning:
- Bubbles tend to be created when the price people are willing to pay become disconnected from the value of the underlying assets. Index are largely valuation insensitive. In fact, the most popular indexes are market capitalization weighted, which is a momentum driven strategy.
- In the near-medium term, it seems logical that the flow of money into index funds will continue to drive up the multiples on the index constituents. While the outflows will be painful for active managers, the survivors will to find it easier to find opportunities in the stocks that are underindexed. Bubbles inevitably burst, and that will lead to a number of years where active managers dramatically outperform index funds (and also bring active management back in vogue).
- "Smart" indices based on valuation metrics are a much greater threat than market capitalization weighted funds, but my assumption is that the bulk of the money is currently in the market cap weighted ones. That will likely change in the long-term, but going back to how value investing is extremely difficult to put into an algorithm, it's hard to see how these index funds would be able to a better job at valuing companies than human beings. That will create mispricings that skilled value investors should be able to exploit.
Professor Damodaran,
ReplyDeleteJust curious to hear how passive investing fits into one of the main roles of a stock market - raising capital/allocating capital to the best risk/reward projects. Seems that passive investing would not be the best at this? Would this fit into point 2 of Information Efficiency?
Thanks you.
ReplyDeleteProfessor Damodaran,
Excellent post. A couple of comments (and questions):
(1) I wonder have you read John Kay's book the "Long and short of It" (second edition recently released)?
He makes several similar points in his book to your post. One of the most interesting is his discussion about how retail investors can benefit from the Efficient Market Hypothesis (which he refers to as "illuminating but not true") but also then benefit from their own personal risk preferences/situations and the ability to take a longer view than a fund manager who has to justify their performance in quarterly/yearly reviews and investments that may be currently flavour of the month.
That also seems to be a major theme of your post and it is interesting to think about how both (the Efficent Market hypothesis and trading) can be true, i.e. prices can be reflective of information, retail investors can benefit from the research done by firms and yet still there may be opportunities to invest profitably.
(2) As regards the passing reference to Warren Buffet, it would be interesting to see how much of his returns arise from investment positions (and reinvested dividends etc.) that took place some time ago (Cocoa Cola shares for e.g.).I am not aware of any analysis on this (there must be some) and it would be interesting to see.
I think though that one of Buffett’s selling points is that he is not necessarily required to "actively trade" and his position and returns during the dot.com period may bear this out.
(3) As regards the role of active traders and market efficiency, Private Equity firms and taking firm’s private surely features in the dynamic here as well as active trading?
Regards,
Ian
Hi Professor,
ReplyDeleteThanks as always for the incredible knowledge you are willing to share. I have to say that I am really dismayed. You have done such a great job keeping us on the right track and preventing us from making excuses for poor valuations. However, you have made some really compelling reasons to just place my savings into a mutual fund and walk away.
In your final paragraphs, you outline why you choose to be an active investor. It almost seems like the reasoning a scientist would give to an engineer for why they toil in the lab without a commercial purpose. Yet, we are seemingly here with a very real commercial purpose. Moreover, yesterday you demonstrated that the class' valuations beat the market, on average.
Certainly, there has to be some value generated from the due diligence and adherence to the first principles?
Thank you!
Excellent article, Professor Damodaran. Your insight from the Stiglitz article is especially thought provoking.
ReplyDeleteHedge funds which benchmark against an index such as the S&P 500 and can go anywhere, invest in bonds, loans, distressed debt, currency, etc is not what the Prof is talking about and hence, perhaps, some of the confusion surrounding returns on an index and the word "collectively". He is limiting the investment option to only common stocks; otherwise the 60% who some ask about earning more than the 10% in his example will be able to earn more; they cannot, however, if they invest only in stocks as is the case with the index investor.
ReplyDeleteA question is whether or not the move to index/passive investing, particularly with the rise of ETF's has led more volatility in the markets making it even tougher for the stock picker to outperform is a question.
It seems to me that the rise of passive investing provides greater support (no pun intended) for the technical analysis crowd and technical analysis might take on greater gravitas in an increasing world of passive investing.
Prof.,
ReplyDeleteI am wondering how you define a passive investment vs an active investment?
You write "you can create passive investing vehicles (index funds of just low PE stocks or PBV stocks) that will deliver those excess returns at minimal costs." Some people may consider anything that deviates from the global market cap portfolio an "active" investment, even if it comes in the form of an index.
Thanks
Professor Damodaran,
ReplyDeleteI am actually writing a dissertation in the subject and on the economic consequences of passive vs active investing. Wooley and Bird actually made comment on the idea that "active investing will ebb and flow over time" in a 2002 paper. They argue that the re-balancing of undervalued stocks being bought by active investors would actually not result in the market coming back to somewhat more realistic valuations.
Quote:
"In such a world some equilibrium mix between actively and passively managed funds will evolve consistent with no long-term inefficiencies in markets.
In contrast to what is presumed by Lorie and Hamilton, this paper suggests that markets are unable to identify where the allocation to index investing has gone too far, and so the natural corrective mechanism suggested in the previous paragraph just will not eventuate. The important fault in their logic is that one would not expect active managers to be able to outperform the index irrespective of the extent to which markets might become inefficient. In order to illustrate this point, assume that 50 per cent of investors in a market follow an active strategy, with the other 50 per cent following a passive strategy.
Assume that the market returns 20 per cent over a period and the indexed fund actually earned this 20 per cent. Then what will be the return earned across all of the actively managed funds?
Obviously, it will have to be 20 per cent (ignoring fees) and so there is no way that a comparison between the average return earned by the active managers with the index return will make investors aware that markets have become efficient.1 In other words, the warning light to signal that markets have become inefficient will never light up and so there is no reason to expect that investors will come to a realisation that the flow of investment funds to index investing has gone too far — meaning that the envisaged constraint on the flow of funds to index investing is unlikely to eventuate."
I would welcome a comment.
Thank you,
Louis
I agree with your analysis that market share for active management will continue to erode but I do not fully agree with your rationale provided in point 1. Your claim that
ReplyDeleteThus, active money managers have to start off with the recognition that they collectively cannot beat the index and that their costs (transactions and management fees) will have to come out of the index returns.
is flawed from circular reasoning. The empirical data shows a lack of consistent performance by the active managers but that doesn't preclude excess returns from active investment.
I would also say that increasing breadth of asset classes and international markets would not have been possible if there weren't active managers seeking alpha opportunities.
Prof Damodaran -
ReplyDeleteIf we do see an active/passive mix of 20%/80%, how does a young equity analyst protect his/her job? What do you tell all of your students that are preparing for life after school?
Thank you,
Devin
The problem with this argument longer term will be the definition and the statical data used to form the basis. Index managers are all simple to define where as active managers are diverse and a difficult to group and further group into sub groups to make a meaningful assessment.
ReplyDeleteI wonder how much of the data with the inflows/ourflow chart changes from active to index, is the movement from active managers which were plus or minus 5-10% of the index in their holdings (what I refer to as a dressed up index fund being marketed as an active manager). It will be interesting to watch these charts over time, as the time periods are simply too short to make any meaningful insights into these trends.
Forward looking at the index market it seems this will just be a race to the bottom with the fees eventually reaching 0% as it will be only a matter of time before somebody does this for free, similar to brokerage accounts that are being offered for free and other parts of the financial market.
You also forgot to mentioned that the academics will be disrupted too if your assessment is correct, all those portfolio theory classes will be replaced by a cheap to run computer algo!
It will be an interesting trend to watch. The argument will no doubt surface again once there is a meaningful correction in the market and the algo programs push the downside taking advantage of all that wonderful money just sitting there following the index. There is nothing greater in the world than a herd with group thought thinking this is the way forward.
As I don't see it covered, I have to ask a question on the personal level, as that was the surprise conclusion.
ReplyDeleteIt's just human: how has it worked for you up to now? Do you keep scores? It's your client happy with the results?
I read many of your public investments, but usually we don't get to know the sales, so I don't think scores can be publicly tracked.
As passive indexing (in every category like small, value) has become popular my fear and doubt have become bigger. How will the passive investing change the premiums (like small, value)? Will there be any significant premiums in the future? What is the future of the premiums?
ReplyDeleteDear Prof Damodaran - Your dismissal of Buffet, Lynch etc seems very baseless. Are you saying only 'the timeperiod of their operation' and 'luck' explains their success? How do you back up this assertion?
ReplyDeleteThanks a lot professor Damodaran for this article ! Very interesting case for passive investing for a valuation teacher and more precisely a DCF valuation method fanatic, i would say.
ReplyDeleteBy the way, as an aspiring Phd student, I just want to know what was the subject of your Phd Thesis ? I remember from one of lectures that you used to work on the January effect or the monday effect, compiling data on these matters ... ? Another, what was your experience to be surrounded of this magnificient minds for your Phd studies years ? I mean you worked close to what we can consider the Godfathers of modern finance : Eugene Fama, Richard Roll and so much more ... Maybe the subject of an article ! It's my sincere hope. Looking to reading you soon on these subjects !!!
Hi Professor,
ReplyDeleteTwo quick questions:
1) Any thoughts on why a greater proportion of active equity investors underperform the index compared to bond or real estate investors?
2) At what point does passive investing become too crowded? i.e. there is too much passive money in the system, the market becomes inefficient, and active investors have more opportunity to profit? Is there an equilibrium breakdown between active vs. passive?
Thanks!
Tony
Dear Professor Damodaran,,
ReplyDeleteThank you kindly for your dedication to teaching and honest research.
In broad terms, it would be very difficult to prove that active investing is more successful than passive investing. Passive ETF simply tracks all of the active investors (minus the performance fees). Some active investors will outperform and others will not, during a given time period. I am not sure you have really proven that successful active investors cannot be consistent.
Here are some arguments for active investing:
1) To assume that active investing is always inferior, you would need to conclusively prove the efficient market hypothesis.
2) We cannot rely on past results to predict future returns. As passive investing becomes increasingly popular, the financial markets may become less efficient, and leave more opportunities for active investors.
3) In Australia, the market is dominated by financial and mining sectors (represents ~50% of top 300 index). Broad ETF investing in Australia often lacks sufficient investment diversity. There are many actively managed funds here that have >5 year history of index outperformance (net of fees).
4) I don't really understand your rebuttal to the "star man" argument. There are countless people that have consistently outperformed the market over decades. Clearly they have succeeded and continue to succeed from active investing.
Warm regards
Sam