"Why the Math Behind Passive Investing May Be Wrong"

The only math I'm willing to say I'm sure of is that you can't have the aggregate of all fee-charging managers match, much less beat, the market. At least I think I'm sure. For the rest of it, the answer is: It depends.

From the Wall Street Journal:

Wesley R. Gray (@alphaarchitect) is the CEO and CIO of Alpha Architect, a quantitative asset manager based near Philadelphia.

For many investors, the superiority of passive investing over active investing is axiomatic.

And why not?

Study after study has demonstrated that only a small portion of actively managed funds beat their benchmarks over long time frames. A recent Wall Street Street Journal article, “The Dying Business of Picking Stocks,” noted that while 66% of mutual funds and ETFs are currently actively managed, this figure is down from 84% 10 years ago.

For many investors, the move into passive investing is simply another form of short-term performance chasing, but for others, the move is much more strategic and backed by persuasive logic. For example, back in 1991, William Sharpe published “The Arithmetic of Active Management,” which laid out the challenges faced by the active-management industry.  Mr. Sharpe argued the market is made up of two kinds of investors: 1) passive investors, who hold the market-cap weight of every stock in the market, and never trade, and 2) active investors, who individually hold portfolios that differ from the market, and actively trade.

Mr. Sharpe’s “arithmetic” concluded the following: 1) passive investors earn market returns, and 2) active investors play a zero-sum game–for every winner there is an offsetting loser. The implications are profound for active investing because after deducting management fees, active investors must underperform passive investors, on average. The natural conclusion is for investors to simply punt on higher fee active management and invest all their capital in ultra-low-cost passive strategies.
Mr. Sharpe’s logic is compelling, but I think the assumptions underlying the conclusions are not grounded in reality.

A recent essay by Druce Vertes at the CFA Institute, and more formal research by NYU Professor Lasse Pedersen, suggests that Mr. Sharpe’s conclusions might be incorrect. Dr. Pedersen offers a very powerful critique in a new white paper entitled, “Sharpening the Arithmetic of Active Management.” Dr.  Pedersen argues Mr. Sharpe’s arithmetic relies on the faulty assumptions that the market never changes and passive investors never need to trade.

Objectively, these assumptions are false: The market is not static, as new firms are created through IPOs, new shares are issued or repurchased, and indexes are reconstituted all the time. Additionally, passive investors must sometimes rebalance their portfolios, for instance to raise cash or reinvest dividends. In short, passive managers must, and do, trade with active investors.

As evidence for the need of passive investors to trade, Dr. Pedersen cites the case of a theoretical passive investor in 1927, who never trades. After 10 years, this investor owns only 60% of the market. And this ongoing market turnover is persistent: The average turnover for all equities from 1926 through 2015 was a whopping 7.6% per year. Last year, the Vanguard 500 Index Fund reported turnover of 10%. Clearly, the assumption that passive investors never need to buy and sell is false. And this mechanical need to trade opens passive investors up to exploitation by active investors....MORE