Wednesday, July 23rd, 2014
you get the market

The debate between the believers in passive investment management and the believers in active management is destined to go on ad infinitum.  But the simple truth is that they are much more alike than different in terms of results.

To simplify things, let’s look at the stock market, specifically the U.S. stock market.  For investment professionals, the “market” has long since meant the S&P 500, although there are other measures that capture more of the market than it does.

The market thus described is weighted by capitalization and serves as the benchmark for huge numbers of active managers who are generally judged and rewarded (or not rewarded) based upon their relative performance versus that benchmark.  The active/passive debate revolves around which of those approaches is likely to produce better returns over time.  There are other issues — including the wisdom of spending gobs of time and money trying to outperform when history appears to not be on your side — but that’s the big one.

So, the passive investor owns the market or something that resembles it and gets a volatile stream of returns.  That volatility is thought of as the price paid (including the emotional price paid) for higher returns over time.  Faith in that trade has been severely tested over the last fifteen years, but passive management keeps gaining adherents.

Now, what does the active investor get?  The results obviously vary depending on the manager that is selected to do the investing (most of whom have failed to beat the indexed approach), but they adhere closely to the patterns of the market itself.

Either way, in the big scheme of things, you get the market.  Relatively few “traditional” active managers produce a pattern of results that is very dissimilar from the passive approach.  Some might be able to show a small amount of market-beating “alpha” in their statistical analyses, but what’s there is primarily “beta,” the movement of the market.

If you deliver beta, you should get paid for beta, meaning that the fees charged by many managers should come under even more pressure than they have.  Thus, passive solutions are forming one flank of the battle active managers face, not because they are necessarily better (we don’t need to decide that point), but because the extra fee load for active management does not deliver a substantially different experience.

On the other flank are what might be called “alpha” managers (who are increasingly being placed into a bucket with the label “alternatives” on it).  To make it simple, let’s just focus on those who use the raw materialthe research puzzle | That was the name of a recent posting about the analysis of alternatives. of equity securities to weave their magic.  Not only are they trying to produce a return pattern nothing like the two types of beta players above, but they are usually being paid much (much) higher fees to do so.

The promise of a differential pattern is likely why such alpha strategies continue to pull in assets, even as they have lagged beta strategies over the last few years.  That’s not to say that they will deliver on that promise (many won’t) or that they should be paid what they are being paid (they shouldn’t).

But the migration that has dominated institutional portfolios for a while — going from traditional managers to a combination of cheap beta and expensive (apparent) alpha — has become a major factor in the construction of portfolios for individuals too.

You can argue with my assertion that passive and traditional active investors both “get the market.”  After all, it’s not precisely correct.  But they track each other so well — and we expend so much effort comparing them in an extremely narrow context — that we lose sight of the fact that active managers are failing because they are trying to do the wrong thing.

Hanging around the index doesn’t add value.  Institutions and individuals need patterns of return that don’t look like the market, and the evidence to date is that they will pay up for the pleasure.  The ability to do that may be the operative definition of “active management” in the years to come.  If so, we are about to enter into an era of transformation.