Swedroe: Passive Investing Is The Way

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As a follow-on to IndexUniverse?s Q&A with Larry Swedroe of Buckingham Asset Management in March, we thought we?d publish the conclusion of Swedroe?s latest book ?The Quest for Alpha: The Holy Grail of Investing.? As we said then, it?s as trenchant and concise an indictment of active management as you?ll ever encounter.

But, in the spirit of fairness and fun, today we?re also publishing a Q&A with Brian Schreiner of Pa.-based Schreiner Capital Management. Schreiner doesn?t dismiss passive management the way Swedroe tries to dispel the premise of active management, but Schreiner argues that the trend-following active management that his firm specializes in can save investors a lot of heartache, especially in bear markets.

So, if you have any skin in the game in the passive vs. active investing debate,?Swedroe?s well-crafted words and Schreiner?s methodical reasons why he embraces trend-following active management are both worth taking in. So, without further ado, here?s Swedroe?s unapologetic view that passive investing is the only way to go.

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Conclusion

Victor Hugo was a French poet, playwright and author, best known for Les Mis?rables and The Hunchback of Notre Dame. He was also a human rights activist who stated:

There is one thing stronger than all the armies of the world, and that is an idea whose time has come.

Despite the armies aligned against passive investing as the winning strategy, it is an idea whose time has come. Nothing Wall Street or the financial media can do will stop the trend away from active investing.

Arthur Schopenhauer was a German philosopher known for his clarity of thought. He had this to say about great ideas:

All great ideas go through three stages. In the first stage they are ridiculed. In the second stage they are strongly opposed. In the third stage they are considered to be self-evident.

The conventional wisdom on investing has been that the markets are inefficient, and smart people, working diligently, can, after the costs of their efforts, persistently exploit mispricings and deliver alpha. However, as Nicolas Chamfort, an 18^th-century French writer best known for his wit, noted:

There are well-dressed foolish ideas just as there are well-dressed fools.

Just because something is conventional wisdom doesn?t make it right. At one time, ?the Earth is flat? and ?the Earth is the center of the universe? were both conventional wisdom. In other words, even if millions of people believe a foolish thing, it doesn?t make it less foolish. Active management as the winner?s game is a foolish idea no matter how many people believe it, or how fervent their belief. If you have not yet been convinced, perhaps the following will do the trick.

The Yale Endowment Fund

A study on the performance of the public equity investments of the highly successful Yale Endowment found that the returns were fully explained by exposure to risk factors and not manager skill. The endowment?s exposure to small-cap and value stocks provided the excess returns over the Wilshire 5000 (the chosen benchmark). A similar result was found internationally. While the endowment beat its benchmark (MSCI EAFE Index), the outperformance was explained by exposure to emerging market stocks and the same Fama-French risk factors. In other words, the benchmarks were wrong.

The authors concluded that any disciplined investor with a high risk tolerance could replicate Yale?s results using publicly available index funds and some degree of leverage. They added that they saw value in Yale?s broad diversification across asset classes with relatively low correlation.

The implication is striking: If Yale, with all of its resources, can?t identify the future alpha generators, what are the odds you can do so? As Schopenhauer noted about great ideas, the idea of indexing was initially ridiculed. Edward C. Johnson III is the chairman of Fidelity Investments. Note what he said about indexing:

I can?t believe that the great mass of investors are going to be satisfied with just receiving average returns. The name of the game is to be the best.

The following is the typical stockbroker?s pitch when confronted with an investor who asks about indexing as an investment strategy: ?If you index you will get average rates of return. You don?t want to be average, do you? We can help you do better.? Both stockbrokers and Edward Johnson are appealing to what seems to be the all-too-human need to be ?better than average.? They ridicule and oppose indexing because it is the loser?s game for them. And, as you have learned, they confuse market returns (which is what indexing delivers) with average returns. As William Sharpe demonstrated, by accepting market returns, passive investors in aggregate must outperform active investors in aggregate. Listen once again to Jonathan Clements:

It?s the big lie that, repeated often enough, is eventually accepted as truth. You can beat the market. Trounce the averages. Outpace the index. Beat the street. An entire industry strokes this fantasy.

In a great irony, Fidelity is now one of the world?s leading providers of index funds.

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Source: http://www.indexuniverse.com/hot-topics/9290-swedroe-passive-investing-is-the-way.html

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