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Submitted by: Robert J. Schumann
Mr. Schumann and his clients have been quoted in numerous print and online publications including The Wall Street Journal, Smart Money, Kiplinger’s Personal Finance, Money Magazine, MSN Money, the Columbus Dispatch and Columbus Business First. TV appearances include the WCMH Channel 4 News and the NBC Today Show. He is a contributor to Tips from the Top--Targeted Advice from America's Top Money Minds, edited by Edie Milligan and published by Alpha, 2003.
Use Passive Managment to Lower Costs
Since the early 1970s there have been two competing theories on how to get better investment returns. Active Management is the oldest and still most widely held. The goal of active management is to “beat the market”. About 93% ($6.5 trillion) of all mutual fund dollars are actively managed.
Passive Management is the new theory which emerged from Nobel prize winning research originating in the 1950s. The goal of passive management is to “match the market” and get better returns by keeping costs down. About 7% ($500 billion) of all mutual fund dollars are passively managed.
Active management begins with the assumption that stock and bond prices do not always reflect their “true” or “intrinsic” value. Active managers spend billions of dollars on research to find the “mispriced” securities. Using fundamental analysis, technical analysis and market timing, professional money managers actively trade (buy & sell) securities in search of higher investment returns.
In the 1960s researchers began to publish evidence that active management does not work. Instead of beating the market, active management generally produced under performance! Statistical testing of managers who beat the market over 1-, 3-, 5- and even 10– year periods, indicated the results were nothing more than random chance. When illustrating this point in a seminar I ask the audience to stand and participate in a coin toss contest. I flip a coin and invite the crowd to call “heads” or “tails”. Those who call it wrong sit down. After five tosses there are always some still standing who called the toss correctly five times in a row. Then I ask the rhetorical question “Are these people better coin toss callers than the rest of you? Did they know something that you did not?” The answer is always a unanimous “No.” Winning active managers are no different than the winners of my coin toss contest. In a large crowd of thousands of active managers some will be lucky and beat the market average. It’s the mathematical law of probability.
Similar experiments have been conducted using chimpanzees or dart games. Active managers who “outperform” are no different than journalists or chimpanzees that pick winners by throwing darts at the Wall Street Journal stock pages. Excuse me. There are two differences. We do not give the chimpanzees and journalists FIVE STAR ratings. Nor do we give them more money to manage (just as the law of averages is about to catch up with them).
As the data emerged academics came to a startling realization. By definition active managers as a group must under perform the market because of the billions of dollars they spend on research, salaries, transaction costs, etc. An index by itself is a sampling of stocks which represents the market (all publicly traded companies). An index, like the market itself, has no research expenses, no transaction costs, no fees or commissions. You cannot buy the index. You can attempt to replicate the index by buying the stocks in the index or an “index fund”. When John Bogle created the Vanguard S&P 500 Index Fund in 1974 he predicted that it would outperform 60-80% of all actively managed mutual funds. Last year (2004) was the fund’s 30th anniversary. Prof. Burton Malkiel (author of best selling A Random Walk Down Wall Street) reported it had outperformed over 90% of all actively managed funds. Investors who adopt the passive goal of “matching the market” are like golfers who score “par” on 18 holes of golf. Instead of trying “beat the market” they are happy to beat 90% of their fellow investors.
As the evidence accumulated, scholars also began to question the underlying assumption of active management. What if security prices are NOT mispriced? What if at any given moment, the market price of a security is the most accurate assessment of its true or intrinsic value? What if the minds of all buyers and sellers with their ‘bids” and “asks”, function like a giant supercomputer processing all the world’s information on a particular security? Consider how quickly new information, whether it’s bad news or good news, is reflected in stock market prices. What if capital markets are just as efficient as the labor market or the commodities market, or the market for automobiles or the market for toothpaste?
At our last Client Appreciation Dinner, I told our guests that active management is based on The Big Lie. The Big Lie is the assumption that stock and bond markets are not as efficient as all other free markets. Rex Sinquefield calls this Market Failure Theory: “The only people who believe that free markets don’t work are the North Koreans, the Cubans and active managers.” We might add to his list the millions of Americans who continue to invest most of their money with active managers.
But the tide is changing. The “money flow” into passively managed index funds and ETFs is growing faster than the flow to active managers. People are abandoning their belief in active management in the same way they surrendered their belief in a flat earth. There may be resistance from Wall Street, but the knowledge of science does spread. Thirty years ago there were no index funds. As of this writing Vanguard has surpassed Fidelity as the largest mutual fund company in the world and the Vanguard S&P 500 Index Fund is the largest fund in the world. At institutional portfolios, over 33% of all money is now passively managed.
As the tide changes, I would like to recommend another investment company that uses passive management -- Dimensional Fund Advisors. DFA, like Vanguard, was founded about 30 years ago. DFA’s “asset class investing” with “structured portfolios” is a little understood alternative to index funds. More about that next month.
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