Earth to Passive Investors: Lunch is Never Free.

Earth to Passive Investors: Lunch is Never Free.

November 7, 2016 Uncategorized, Tactical Asset Allocation Research, Active and Passive Investing, Macroeconomics Research
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(Last Updated On: January 1, 2017)

Imagine the following scenario:

  • A strategy that outperforms everything.
  • An ability to scale the strategy at no costs.
  • A beating drum highlighting the infallible logic of the strategy.
  • And the best part is this strategy costs an investor next to nothing.

What could possibly go wrong in this scenario?

no-free-lunch

Unfortunately, the scenario above maps out a lot of the current thinking in so-called passive management.

Problem #1: there is no such thing as the passive market portfolio. As Cullen Roche highlights, passive investing is a myth.

Problem #2: passive investors in the real world mechanically need to transact with active investors — they can’t avoid this reality unless they are a mythical “representative agent” in some wack-job theoretical asset pricing model.

Lasse Pederson, a professor at NYU and a principle at AQR, has a great paper called, “Sharpening the Arithmetic of Active Management,” which summarizes the two problems above. Highly recommend all investors read this piece.

Also, we summarize Lasse’s piece, as well as some great pieces from others on this topic of passive investing eating the world.

http://blogs.wsj.com/experts/2016/11/06/why-the-math-behind-passive-investing-may-be-wrong/

 


Important note:

Passive is a great thing for the investment public and the ability to access exposure to generic market risks at low costs is an incredible innovation in financial services. We consider Jack Bogle a God in the financial services space. But even Vanguard is aware of their vulnerability in the market. See Vanguard’s presentation to the SEC here.

The WSJ piece merely highlights that active investing IS NOT a zero sum game where active players simply steal alpha from one another.

The gross “alpha” comes from services they are providing to passive investors. Lunch is rarely free in a competitive market.

But gross alpha doesn’t mean investors benefit from active management. We also think that costs matter — always. But so do value propositions.

For example, active management never works if the costs are too high for the long-term expected benefits being delivered, however, affordable active might be a win-win.

Bottomline: know what you are buying and why you are buying it.

 

 

 

 

 


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Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.


  • The extreme situation – all passive, no active – is of course impossible. But an interesting question – and I would be curious, Wes, as to your guess – is when we cross the rubicon (i.e., at what percentage passive do the economics of passive start to deterioriate)?

    Nick de Peyster
    http://undervaluestocks.info/

  • No impact, no idea.