Top 400: Active and passive - An ongoing debate
Can markets offer investors better price discovery for a lower spread?
- Is the shift to passive value-enhancing or value-destroying for society?
- There is evidence that financial markets have become more efficient.
- A future model could be more passive and concentrated active management.
The trend of shifting investment allocations from active to passive management has accelerated in recent years. According to Credit Suisse, investors have withdrawn nearly $1.2trn (€1.1trn) from actively managed US equity mutual funds since end-2006, and have allocated about $1.4trn to US equity index funds and exchange-traded funds1 (ETFs).
It is simply a mathematical fact that active investing in aggregate produces market returns minus costs. Empirical evidence overwhelmingly supports the findings that net of fees, most active managers underperform the market. Does it really make any sense for most investors, particularly those that are less informed, to engage in this negative-sum game?
On the other hand, active investing does produce a valuable social good: the discovery of so-called efficient prices for all financial instruments, a key foundation upon which market-driven capitalist systems are built. An economy with no active investing would be extremely inefficient from a capital allocation point of view.
One of the key questions to address in this debate, albeit often overlooked, is whether the current balance of active versus passive is appropriate from an aggregate or society point of view, which in turn would inform whether the current shift towards passive is value-enhancing or value-destroying for society.
To answer that question, let’s evaluate active management as a social good, by comparing the aspects of price and value. Warren Buffett once famously made the statement that “price is what you pay and value is what you get”. The net gain for the society is the difference between two: value v minus price p.
The price/cost of price discovery is relatively easy to calculate. One can measure the total amount society spends to invest a and then compare this cost with what society would pay if all investors held a passive market portfolio b – the difference a-b is the cost of active investing/price discovery. Kenneth French used this logic in his 2008 American Finance Association presidential address, suggesting that for the period of 1980-2006, investors on average spent
67bps of the market cap in the US for price discovery p.
The value element is, however, much trickier. In theory, it is the economic loss to society due to inefficient asset prices in a hypothetical state where there is no active investing at all compared to another hypothetical state where prices are completely efficient. (Grossman and Stiglitz, however, made it clear that pure efficiency is fleeting: market inefficiencies are a necessary incentive for investors to engage in active investing). In practice, the value of price discovery is difficult, if not impossible, to calculate.
A new study by two Wharton professors2 addressed a different but relevant question: how much potential value could society gain if all informational inefficiencies in current asset prices were eliminated? The authors quantitatively assessed the real value losses associated with financial market anomalies. It is well known that firms make the wrong investment decisions as a result of distortions in market prices and the cost of capital. The maths is complicated but the conclusion is clear: society could gain value that is worth about 11% of public firm net payouts for eliminating price inefficiency completely.
I have used free cash flow as a reasonable proxy for the paper’s net payouts. Given the reading of free cash flow yield for the S&P 500 of 4.7% (as of 23 Jan 2017), the potential value to society of eliminating all existing price inefficiencies in the S&P 500 is about 50bps of the market cap. This finding, that there is still value on the table, provides an incentive for the job of price discovery, from a societal point of view. The lack of a suitable counterfactual, however, means that we cannot quantify directly the amount of value v that active management has delivered from a base of complete market inefficiency. Nonetheless it is probably reasonable to assume that the more efficient financial markets are, the less the economic gain would be from further reducing pricing anomalies and the higher the value society was deriving from active investing (everything else being equal).
There is evidence suggesting that financial markets have become more efficient. Bai, Philippon and Savov claim that using certain measures, prices in financial markets were 80% more efficient in 2010 than 1960, well before the first ever index fund was launched3. The upward trend in improving market efficiency is steady throughout the 50-year sample. Along with a shift towards passive, in the last few decades we have also experienced the rise of high-cost and highly-active alternative sectors like hedge funds. It is plausible to suggest that these two trends have together produced better price discovery for society v.
How about the cost p? The aforementioned study by Kenneth French covered a shorter period of 1980-2006 and his data indicated a relatively stable p throughout the entire period (starting with 64bps in 1980 and ending at 66bps in 2006; 1983 and 1986 saw the highest 74bps and 1981 saw the lowest 56bps).
The investment world is a complex system, and we have written about this in more depth in a white paper entitled Stronger Investment Theory4. A property of such a system is that it exhibits emergent outcomes arising from the interactions of the participants that cannot be deduced simply by aggregating the properties of these participants – it is a system where the whole is greater than the sum of its parts. Complex systems are, among other things, adaptive and evolving. If we compare financial markets today with any previous point in time, we will see remarkable changes and yet seldom have these changes appeared material at the time.
In this live system, it is not the strongest of the species that survive, nor the most intelligent, but the one most adaptable to change. There is no universal truth. There are only temporary hypotheses, which can be discarded and replaced by the financial markets acting as ‘search engines’.
In this context, the ‘search engine’ seems to have found a more optimal solution – better price discovery for the same spend. It looks to have achieved that by moving from a state of predominantly active investing to one that combines both cheap passive and expensive highly active.
So much for the past, what happens now? While it would be hubristic to attempt to predict where a complex system is heading, it is reasonable to expect that this system will continue to search for an even better position. One of the possible future scenarios could involve more in passive, lower fees on hedge fund allocations, and a further shift from 200-stock traditional active portfolios to 20-stock high-conviction portfolios – that is even lower spend for (potentially) even better price discovery. It, of course, hinges on the enablers of price discovery – diversity of risk preferences, cognitive thinking and time horizon in markets – not being impaired by the further shift towards passive.
1 Looking for Easy Games, Mauboussin, Callahan and Majd, Credit Suisse
2 ‘Real Anomalies’, Van Binsbergen and Opp, 2016
3 ‘Have Financial Markets Become More Informative, Bai, Philippon and Savov, 2015
4 Thinking Ahead Institute, 2016
Liang Yin, CFA, PhD, is senior investment consultant in the Thinking Ahead Group, an independent research team within Willis Towers Watson and executive to the Thinking Ahead Institute