Earth to Passive Investors: Lunch is Never Free.
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?
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.
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.
Note: This site provides no information on our value investing ETFs or our momentum investing ETFs. Please refer to this site.
Join thousands of other readers and subscribe to our blog.
Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.
Definitions of common statistics used in our analysis are available here (towards the bottom)