Earth to Passive Investors: Lunch is Never Free.

Earth to Passive Investors: Lunch is Never Free.

Print Friendly, PDF & Email
(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.

 

 

 

 

 


  • 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. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).
  • Join thousands of other readers and subscribe to our blog.
  • This site provides NO information on our value ETFs or our momentum ETFs. Please refer to this site.

About the Author:

After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. 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.