Article on Active vs. Passive

[rocketdog]

Nice article that uses graphs to sum up the recent disparity between active & passive approaches.  But check out Gov't Long Duration funds towards the end of the article -- pretty bad performance compared to their benchmark:

http://seekingalpha.com/article/1318701 ... aily&ifp=0

[MachineGhost]

That was a pretty weak article, especially at the end where he displays no acumen as to why "active management" would be beating the indexes in short bond durations and concludes that there is more opportunity in bonds than equities.  That's so false.  I wouldn't even call any of this skill when the period in question is only three years.

IMO, what can be said is that active management by Wall Street fails to outperform a super-majority of the time on the average.  Wall Street's behavorial and institutional constraints are the largest reasons why.  But I see passive advocates, such as the broken record Bogle, taking it out of context and applying it to everyone universally, irregardless of their skill level.... some kind of bizarre legacy of CAPM.  Also built into that kind of argument seems to be the presumption that those on Wall Street are "professionals" and are better at the job than anyone else.  That is a laughable tautology.  Now sure, Mom 'n Pop would be better off avoiding average Wall Street active management and doing no worse than passive management, but they would also be better off with above average active management.  In summary, Bogle advocates for the muppet's and that is certainly honorable within that context.

But yeah, I'm probably wasting my time expositioning.  Muppets will believe what they are told, whether that is active management only or passive management only.   What's lacking is critical thinking skills in both extremes.  But then isn't that why they are muppets in the first place?  At some point its pointless to continue to debate as people rarely change.

[rocketdog]

That was a pretty weak article, especially at the end where he displays no acumen as to why "active management" would be beating the indexes in short bond durations and concludes that there is more opportunity in bonds than equities.  That's so false.  I wouldn't even call any of this skill when the period in question is only three years.

IMO, what can be said is that active management by Wall Street fails to outperform a super-majority of the time on the average.  Wall Street's behavorial and institutional constraints are the largest reasons why.  But I see passive advocates, such as the broken record Bogle, taking it out of context and applying it to everyone universally, irregardless of their skill level.... some kind of bizarre legacy of CAPM.  Also built into that kind of argument seems to be the presumption that those on Wall Street are "professionals" and are better at the job than anyone else.  That is a laughable tautology.  Now sure, Mom 'n Pop would be better off avoiding average Wall Street active management and doing no worse than passive management, but they would also be better off with above average active management.  In summary, Bogle advocates for the muppet's and that is certainly honorable within that context.

But yeah, I'm probably wasting my time expositioning.  Muppets will believe what they are told, whether that is active management only or passive management only.   What's lacking is critical thinking skills in both extremes.  But then isn't that why they are muppets in the first place?  At some point its pointless to continue to debate as people rarely change.

Economists and academicians also advocate for passive strategies.  At least one Nobel prize has been won for research in this area.  I'll take investing advice all day long from economists and academicians who have nothing to sell me over that of fund managers who do.  If that makes me a muppet, then a happy muppet I shall be!

[melveyr]

The thing is that markets being efficient is a sufficient reason for indexing, but not a necessary one.

The indices return the gross aggregate investment returns, minus a minuscule total expense ratio. The active community returns the gross aggregate investment returns minus a larger total expense ratio.

When aggregated, the indexing population always beats the active population. That is true regardless of market efficiency.

[MachineGhost]

Economists and academicians also advocate for passive strategies.  At least one Nobel prize has been won for research in this area.  I'll take investing advice all day long from economists and academicians who have nothing to sell me over that of fund managers who do.  If that makes me a muppet, then a happy muppet I shall be!

Don't kid yourself.  Economists and academicians have a vested interested in selling you on their particular world-view (and as we all know, just about every economist that receives a Nobel Prize has ideas of very little practical relevance or any real success in the real world).  Just like fund managers, they will ignore the bad, for the sake of the good...  whether intentionally or as part of their cognitive biases.  Hence, it is a very polarized situation of two extremes.  I suggest rather than be come inflexible and dogmatic, take the best from both.

[rocketdog]

The thing is that markets being efficient is a sufficient reason for indexing, but not a necessary one.

The indices return the gross aggregate investment returns, minus a minuscule total expense ratio. The active community returns the gross aggregate investment returns minus a larger total expense ratio.

When aggregated, the indexing population always beats the active population. That is true regardless of market efficiency.

That is exactly how William Sharpe -- Nobel prize winner, Standford Finance Professor, and inventor of his namesake ratio -- explained it over 20 years ago:

http://www.stanford.edu/~wfsharpe/art/active/active.htm

[rocketdog]

Don't kid yourself.  Economists and academicians have a vested interested in selling you on their particular world-view (and as we all know, just about every economist that receives a Nobel Prize has ideas of very little practical relevance or any real success in the real world).  Just like fund managers, they will ignore the bad, for the sake of the good...  whether intentionally or as part of their cognitive biases.  Hence, it is a very polarized situation of two extremes.  I suggest rather than be come inflexible and dogmatic, take the best from both.

Academicians have to publish in peer-reviewed journals.  If they're wrong, their peers will eagerly take them to task for it.  After all, the facts are what they are.  It's the scientific method, and I'll take that any day of the week over what the pundits are touting. 

[MachineGhost]

When aggregated, the indexing population always beats the active population. That is true regardless of market efficiency.

It does seem reasonable to me to use the aggregate average as the baseline to do no worse.  We can't expect all but a small minority of dedicated and passionate active managers to be above average because they are all human with lots of sins that impede their success.  Especially when it is just a job rather than a vocation.

[MachineGhost]

Academicians have to publish in peer-reviewed journals.  If they're wrong, their peers will eagerly take them to task for it.  After all, the facts are what they are.  It's the scientific method, and I'll take that any day of the week over what the pundits are touting.

Actually, Sharpe has been taken to task.  The Sharpe ratio is flawed and beta is invalid.  But see, this is the difference between academia and the real world of street smarts.  Have you personally seen any kind of transformation between Sharpe being invalidated and any change in the real world as a result?  Heck, Sharpe is still pushing his invalidated theories as retirement advice to hundreds of thousands of employees via Financial Engines.  The greed of Wall Street and the hubris of academia makes for a very strange form of institutional cronyism.

And let us not forget the Noble Prize winners at the head of LTCM.  Brilliant.

[melveyr]

Academicians have to publish in peer-reviewed journals.  If they're wrong, their peers will eagerly take them to task for it.  After all, the facts are what they are.  It's the scientific method, and I'll take that any day of the week over what the pundits are touting.

Actually, Sharpe has been taken to task.  The Sharpe ratio is flawed and beta is invalid.  But see, this is the difference between academia and the real world of street smarts.  Have you personally seen any kind of transformation between Sharpe being invalidated and any change in the real world as a result?  Heck, Sharpe is still pushing his invalidated theories as retirement advice to hundreds of thousands of employees via Financial Engines.  The greed of Wall Street and the hubris of academia makes for a very strange form of institutional cronyism.

And let us not forget the Noble Prize winners at the head of LTCM.  Brilliant.

Yes I think both the practitioners and the academics must be taken with grains of salt. Academics go to their grave with wrong ideas and the practitioners always have a new expensive wrong idea to sell you!

[rocketdog]

Don't get me wrong: I'm not saying the academics are perfect and above making mistakes.  All I'm saying is that given a choice, I'll take the academics' advice in the aggregate over that of the Wall Street pundits and prognosticators.  One is relying on mathematics and statistics, the other on hunches and emotions. 

[Bean]

I read story after story where active always gets beat in time.  So you would need to market time from strategy to strategy to get active to work. Who has that crystal ball?

Edit: Meant active not passive gets beat in time. Was a late night

[craigr]

Even if all the active managers were above average (how would that work?), they still lose because of the costs to implement the strategy.

Morningstar shows that average active fund fees are usually around the 1.3-1.5% a year range. These managers need to not just beat the average, but need to beat it after they remove their fees. And, they need to do it year after year after year.

If I were a gambling man, I'd wager on the low cost index being the winner in that scenario every time.

[AgAuMoney]

When aggregated, the indexing population always beats the active population. That is true regardless of market efficiency.

Totally true.

And totally worthless.

[AgAuMoney]

If they're wrong, their peers will eagerly take them to task for it.  After all, the facts are what they are.  It's the scientific method...

That is not true.

If they disagree with the commonly accepted notions their peers will eagerly take them to task for it, regardless of the facts.

For example, 20 years ago a doctor at Harvard Medical was literally laughed out of his job for proposing that high cholesterol was not only not the cause of heart disease, but was also not correlated with heart disease.  He has his job back now, and not because HE changed.

It is even worse when talking fuzzy ideas and statistical analysis like 100% of stock market research.

And as for "the scientific method", that requires theories be testable, which means falsifiable.  That means NO economic or investing theory is based on the scientific method.

[WildAboutHarry]

Academicians have to publish in peer-reviewed journals.  If they're wrong, their peers will eagerly take them to task for it.

The peer-review process is pretty good, but far from perfect.  An academic friend of mine once said, and I don't think he was kidding, that making mistakes in research papers is a good way to increase one's publications.  Make a mistake in one paper, correct it in another, etc., etc.

And remember that one's "peers" usually constitute a somewhat inbred, inward-looking, don't-rock-the-boat-too-much group.

[rocketdog]

Academicians have to publish in peer-reviewed journals.  If they're wrong, their peers will eagerly take them to task for it.

The peer-review process is pretty good, but far from perfect.  An academic friend of mine once said, and I don't think he was kidding, that making mistakes in research papers is a good way to increase one's publications.  Make a mistake in one paper, correct it in another, etc., etc.

And remember that one's "peers" usually constitute a somewhat inbred, inward-looking, don't-rock-the-boat-too-much group.

Rocking the boat is what makes someone a legend in their field.  If you can disprove someone else's hypothesis -- or better yet disprove a full-blown theory -- then you go to the front of the class.  That gives (most) academics enormous incentive to "rock the boat", which is what makes the whole process work in the long term. 

My favorite example of this is the common gastric ulcer.  For decades it was generally accepted that spicy or acidic foods were the cause.  Then 2 physicians named Barry Marshall and Robin Warren set out to "rock the boat" and see if that was really true.  In 1982 they discovered that gastric ulcers were actually caused by a bacteria.  They were at first disbelieved, but as their peers reviewed their research and retested their claims, they were proved right.  As a result, in 2005 they were awarded a Nobel prize for their findings, and their research has lead to a better understanding of how stomach cancer works. 

The opposite is also true.  You probably remember the "Cold Fusion" debacle in 1989 created by Stanley Pons and Martin Fleischmann.  They publicized their findings to the media before allowing the normal peer review process to take place.  Their peers found fatal flaws in their methodology and they were publicly and professionally humiliated for it. 

There are other such cases which give encouragement to other researchers to "rock the boat" whenever possible... as long as they don't also try to evade the peer review process.

[MachineGhost]

Even if all the active managers were above average (how would that work?), they still lose because of the costs to implement the strategy.

Those costs are already taken into consideration to be qualified as above average.

I don't think markets can work if everyone is above average though.  That would imply there's no disagreement about value and hence no reason to do an exchange.  Any transaction that is voluntary may be win-win on the superficial surface, but there is always a loser who has lesser knowledge.

[MachineGhost]

I read story after story where active always gets beat in time.  So you would need to market time from strategy to strategy to get active to work. Who has that crystal ball?

That's false.  You merely need to be less stupid than the market, both the muppets and the "professionals".

[MachineGhost]

And as for "the scientific method", that requires theories be testable, which means falsifiable.  That means NO economic or investing theory is based on the scientific method.

I wouldn't go that far.  Backtesting is a great tool to falsify many economic and investing theories touted as true.  What is a real mystery to me is why human beings ignore what is falsified.  Is there something peculiar about the envy/greed bias that throws reason and logic out the window?

[MachineGhost]

There are other such cases which give encouragement to other researchers to "rock the boat" whenever possible... as long as they don't also try to evade the peer review process.

I think you're blowing up rare exceptions to the norm way out of proportion.  You probably have no direct experience with ostracization and ridicule which is always vicious and petty.  If you want to suffer under that for 20-30 years, possibly longer until the bully generation dies off, then by all means, rock the boat in your field.  For the same reason humans rarely rock the boat is the same reason the vast majority of active managers suck.

[craigr]

Even if all the active managers were above average (how would that work?), they still lose because of the costs to implement the strategy.

Those costs are already taken into consideration to be qualified as above average.

I don't think markets can work if everyone is above average though.  That would imply there's no disagreement about value and hence no reason to do an exchange.  Any transaction that is voluntary may be win-win on the superficial surface, but there is always a loser who has lesser knowledge.

The market index is the average. The problem active strategies have is they must be in the top half, after expenses, every year. Doing it a few times in a row won't cut it. One bad year will wipe out the good ones. They need to do it year after year with certainty. The index is what everyone is using as their benchmark to prove themselves.

I remember when US car companies were going on an ad spree attacking the Honda Accord. I saw ads from Ford, GM, etc. comparing their vehicles to the Accord. I thought to myself: "Obviously the Accord is the car to buy because all these other guys are gunning for it. It must be pretty good." The Honda had become the benchmark (for good reason).

Same for the index. The industry compares stock trading against the S&P 500 or broader index. It is, after all, the benchmark. And unlike other benchmarks in the world that could be quite expensive (Ferrari, etc.), this benchmark is ironically the cheapest thing to buy. For me it's a no-brainer to just own the benchmark and leave the active managers fighting amongst themselves for the crumbs.

[MachineGhost]

I remember when US car companies were going on an ad spree attacking the Honda Accord. I saw ads from Ford, GM, etc. comparing their vehicles to the Accord. I thought to myself: "Obviously the Accord is the car to buy because all these other guys are gunning for it. It must be pretty good." The Honda had become the benchmark (for good reason).

Same for the index. The industry compares stock trading against the S&P 500 or broader index. It is, after all, the benchmark. And unlike other benchmarks in the world that could be quite expensive (Ferrari, etc.), this benchmark is ironically the cheapest thing to buy. For me it's a no-brainer to just own the benchmark and leave the active managers fighting amongst themselves for the crumbs.

That's a great analogy except the S&P 500 isn't a passive index nor is it the best constructed index on par with a Honda Accord... more like a Chevrolet Vega.  So, this would imply that if active managers can't even beat what is a subpar index, they're just hopelessly lost to all the cognitive and institutional biases.  And over time if informed investors adopt better benchmarks for the standard to compare to, it will become even more and more difficult for active managers to sustain an edge.  I'm not worried about that happening anytime soon, though.  Maybe within 10-20 years as more and more "worthless" jobs are eliminated through Baxterification.

[Bean]

I read story after story where active always gets beat in time.  So you would need to market time from strategy to strategy to get active to work. Who has that crystal ball?

That's false.  You merely need to be less stupid than the market, both the muppets and the "professionals".

Do you have proof?

[AgAuMoney]

And as for "the scientific method", that requires theories be testable, which means falsifiable.  That means NO economic or investing theory is based on the scientific method.

I wouldn't go that far.  Backtesting is a great tool to falsify many economic and investing theories touted as true.

That is totally and completely insufficient.

A scientific theory has to predict the future, not predict "what if" in the past.  The past can be a start.  But the test is predicting the future.  And it must be falsifiable.  You simply cannot measure much less control all the variables necessary to do that with macro economics or stock market.