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The Misguided Active vs. Passive Debate

Updated: Jul 20, 2023

The world of investment management is sharply divided into two camps – active and passive investing. Active investors believe that making educated decisions with better information and analysis will lead to better than average results. Passive investors believe that simply buying and holding a diversified basket of securities will lead to superior performance over active managers by keeping costs low. The classification of investment styles into either active or passive has led to substantial confusion where both sides believe the other method is destined to fail.


The problem with having two distinct camps of investing is sort of like that of our two-party political system; it implies that the division between the two is concrete and well-defined. Like most things in life-- and especially in investing and politics-- that is not the case, and the truth lies somewhere in between. As was proven on our social media accounts every day throughout the presidential election, people who become entrenched in their positions tend to close their minds to conflicting information. As I see it, the problem is that we have endured more than a decade of frequent and aggressive Wall Street marketing campaigns supported by famous professors and portfolio managers that have led to a polarization of their positions, and their supporters’ cognitive dissonance has caused them to invent reasons to justify those positions.


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1990 Economics Nobel Laureate William Sharpe presented a now legendary argument that active management is a zero sum game, and net of the higher associated costs the average active manager will underperform the passive investor. He made the correct argument that in a market with thousands of equity mutual funds, the stock market index would reflect the aggregate dollar weighting of their respective portfolios. If they charge a fee that exceeds the cost of investing in the index fund alternative, then they can be expected to underperform as a group.


So, while we agree that Sharpe’s game theory logic is sound, there are limits to his arguments, and there are other implications that both active and passive investors seem to overlook. For example, his argument does not rule out the possibility-- the reality-- that some funds consistently outperform the market index. It is just mathematically impossible for all of them to outperform the index because they are the index; no group of people engaging in any activity can be above average relative to themselves.


Let’s look at it like poker. In the game of poker, 90% of all players lose because there is a commission charged to play, and as a result, on average the decision to play poker is a losing proposition. However, there are plenty of professional poker players who win consistently. It is just impossible for poker players as a collective to win, since they are competing against each other while paying a fee to do so.


So, if we’re to believe that it’s impossible to beat the market (which I don't), then investing is just a function of maintaining a balanced portfolio and keeping your costs down. Keeping costs down is important, sure, and when it comes to outperforming the market, it is true that most money managers will not, just like most poker players will lose.


It’s also true that most kids on your local junior varsity basketball team cannot slam dunk. However, if you’re looking for somebody to slam dunk and you go to a Lakers game instead of a local JV game, well, the story changes a little. Same with investment managers; you’ve just got to know where to look.


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According to Goldman Sachs’s preliminary Q4 earnings results, 69% of S&P 500 companies beat street-wide earnings estimates by one standard deviation, significantly above the 46% historical average. However, the beats continued to sell off, with median excess return to the S&P 500 turning negative in Q4. Meanwhile, firms that missed earnings estimates were bought on a relative basis.


This sort of ridiculous market behavior probably belies everything you have ever been told about the stock market, which I suppose could mean one of two things. Either, A.) nobody needs any help with managing their portfolio anymore because all you have to do is read Reddit and buy bitcoin, or B.) everybody needs an advisor more than ever, because if your eye isn’t on the ball for even a moment, you stand to get smoked like a joint.


Just like the active vs. passive debate, the truth is probably somewhere in the middle. While it sure looks like most traditional measurements of fundamental value have been thrown out the window and that technicals have taken over the whole market, the reality is that, when it comes to price corrections, valuations normalize through earnings and time. Anybody who tells you that "it’s different this time" probably has some dogecoin (or whatever they call it) to sell you.





For disclosure information please visit: https://www.rgbarinvestmentgroup.com/terms-and-conditions



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