Best argument you've heard against passive/for active?

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janeway
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Best argument you've heard against passive/for active?

Post by janeway » Tue May 16, 2017 12:48 am

When I feel comfortable in a decision or opinion it's usually because I'm informed enough to argue something from both sides. However I've mostly exposed myself to bogleheads and others with similar opinions so I'm not at that point with investing. I'm therefore curious what are the most convincing arguments people have heard against passive investing or in favor of active investing?

As an example, I read an argument that with index investing you guarantee less than average returns because the fees, while low, are non-zero. The implication was with low-cost active management (still higher fees than indexing obviously) you could try to out perform the average by enough to pay for the fees and come out ahead of passive. The obvious problem with this is that the fees on index funds are VERY close to zero and the probability of out performing the market average by enough to pay for fees is extremely low. The odds of doing so consistently over the long term are basically zero.

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Re: Best argument you've heard against passive/for active?

Post by stlutz » Tue May 16, 2017 1:20 am

what are the most convincing arguments people have heard against passive investing or in favor of active investing?


Vanguard Wellington

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Re: Best argument you've heard against passive/for active?

Post by venkman » Tue May 16, 2017 2:11 am

janeway wrote:As an example, I read an argument that with index investing you guarantee less than average returns because the fees, while low, are non-zero.


Indexing guarantees your return will be slightly less than the index return. But that's irrelevant, because no one can invest directly in an index.

By definition, the combined returns of every investor in the market will equal the market average, minus total fees paid. If you have an exactly-average return minus a below-average fee, you will necessarily end up with an above-average fee-adjusted return.

If you had an active fund that had *exactly* the same expenses as an index fund (including trading costs and other things not included in the ER), you would expect it to beat the index fund 50% of the time. Of course, there would be no way of knowing in advance which times those would be...

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Re: Best argument you've heard against passive/for active?

Post by docneil88 » Tue May 16, 2017 3:37 am

In my opinion, the best argument against passive/for active is the set of arguments in favor of value index funds, which I consider active funds, due primarily to their relatively high turnover as compared to the paragons of passive investing, namely broad market index funds such as VTI/VTSMX (Vanguard Total US Stock Index Fund) and VXUS/VGTSX (Vanguard Total International Stock Index Fund).

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Re: Best argument you've heard against passive/for active?

Post by MrFlish » Tue May 16, 2017 4:14 am

stlutz wrote:
what are the most convincing arguments people have heard against passive investing or in favor of active investing?


Vanguard Wellington



+1

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Re: Best argument you've heard against passive/for active?

Post by KSOC » Tue May 16, 2017 4:45 am

MrFlish wrote:
stlutz wrote:
what are the most convincing arguments people have heard against passive investing or in favor of active investing?


Vanguard Wellington



+1


Wife & I hold Wellington & Wellesley in our TIRAs. With those track records & ER's it feels kinda wrong to call them active. :happy
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Re: Best argument you've heard against passive/for active?

Post by Mr.BB » Tue May 16, 2017 4:56 am

KSOC wrote:
MrFlish wrote:
stlutz wrote:
what are the most convincing arguments people have heard against passive investing or in favor of active investing?


Vanguard Wellington



+1


Wife & I hold Wellington & Wellesley in our TIRAs. With those track records & ER's it feels kinda wrong to call them active. :happy

I also hold Wellington and I also love T. Rowe Price Capital Appreciation fund.
"We are what we repeatedly do. Excellence, then, is not an act, but a habit."

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Re: Best argument you've heard against passive/for active?

Post by NiceUnparticularMan » Tue May 16, 2017 5:51 am

The best argument I have seen is "Active Fund So-and-So has actually beaten the market."

That may not be a very GOOD argument in absolute terms, but really it is the BEST argument you are likely to hear in relative terms.

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Re: Best argument you've heard against passive/for active?

Post by Jack FFR1846 » Tue May 16, 2017 6:27 am

Active management predicts the big ups and big downs of the market and moves from one fund to another to capture the gains in both scenarios.

This is what all the active managers claim. The can also predict who will become president in 2020, what the Dow will be a year from now to the penny and who will win the world series next year.

Alternative facts have always been the staples of active managers.
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Re: Best argument you've heard against passive/for active?

Post by JoMoney » Tue May 16, 2017 6:47 am

For people with a large portfolio, holding individual stocks can be lower cost than even a low cost index fund.

There are potential trading opportunities that can be beneficial to some tax situations.

There are "stock picker" portfolios with lower turnover(i.e. LEXCX, DJIA) *arguably more 'passive'

Various arbitrage opportunities that come up for people who put the time and effort into looking for them.

Business owners should have a voice and and a more active role in what they own, selecting boards and trying minimize the principal-agent risks from entrenched management.

People have different tastes and risk preferences, what may be the aggregate average of everybody may not be a suitable portfolio for any specific individual. Even if the measurable risk/return doesn't justify it, people can have tastes that give them psychological and behavioral benefits.

A focused portfolio (i.e. having holdings of 10% or more in a single stock) has potential to perform differently than an index in a meaningful way.
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Re: Best argument you've heard against passive/for active?

Post by nura » Tue May 16, 2017 6:53 am

stlutz wrote:
what are the most convincing arguments people have heard against passive investing or in favor of active investing?


Vanguard Wellington

+1, actively managed Wellington has beat it's passive counterpart balanced index, inclusive of expenses since the latter's inception while holding less than 10% of the securities found in the index.

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Re: Best argument you've heard against passive/for active?

Post by Buffetologist » Tue May 16, 2017 7:01 am

Having some active funds can make it easier to maintain a certain asset allocation while avoiding wash sales during tax loss harvesting.

Active Vanguard bond funds make it easier to do tax efficient investing for bonds where one can replace treasuries with higher yielding CDs, and can separate muni funds for taxable, and other funds for tax-deferred.
Last edited by Buffetologist on Tue May 16, 2017 9:00 am, edited 1 time in total.

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Re: Best argument you've heard against passive/for active?

Post by harvestbook » Tue May 16, 2017 7:03 am

I've heard risk management used as an excuse-- "We'll be able to get you out before the big downturns."

I am not sure that's convincing, but it sounds good. My personal experience with it is that they're less able to see a big downturn coming than I am, and I don't even pretend to be clever. Yet I am convinced 20 percent of them will find an edge that works for a while, maybe even a third of them, but few will be able to do it over a full 30-year investing life cycle that matters in the real world. They measure themselves on quarters and calendar years while I have to measure against one lifetime. I think I'll stick to the middle road but I am always happy to challenge my theses.

Active bond funds in particular seem to have room for outperformance.
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Re: Best argument you've heard against passive/for active?

Post by nisiprius » Tue May 16, 2017 7:22 am

First of all, I can state a premise that I find credible. I'm not saying it's true, just that I don't reject it out of hand. It goes something like this: there is a market inefficiency that results from there being many participants, whom I'll call "dumb money," who have access to all publicly available information but don't have the time or the ability to use it. In every other field of endeavor, we accept that by and large, on the whole, ordinary mediocre competent professionals really will beat people with absolutely no training or ability at all. So maybe there are enough real suckers in the market for the ordinary competent professional to exploit. (The problem of course is that the vast majority of the dollars in the market are institutional and managed by ordinary competent professionals, but--never mind).

Second, there seems to be decent evidence that actively managed mutual funds... or do we have to add "the usual ones sane people would invest in????" actually do beat the market before fees, but by amounts that are very small. I thought I had seen a genuine academic paper that suggested a number in the ballpark of 0.5%, but I can't find it. One NerdWallet article found that "Active managers outperform the index by 0.12% before fees, but charge more in fees than the value they create." So I don't know if that particular article or number is accurate, but there are a fair number of things I've read that are in that direction. Active managers do create alpha, but they keep all of it for themselves.

Finally, the argument for indexing rests to a great extent on "the majesty of simplicity." It's not that indexing is intrinsically better, it's that "it's as good as anything" or "you can't prove anything else is better." The virtue of simplicity, in turn, comes in part from the virtue of staying the course (which I really believe is true). It is much easier to commit to the market as a whole, than "to commit to a sophisticated strategy that is different from the market during times when it has underperformed the market for twelve or sixteen years." However, it may be possible for people to commit strongly enough to a manager or an active fund in just the way they commit to an index fund. In a way it is just as simple to say "I will commit to Will Danoff" or "I will commit to the big fund in my 401(k) that everyone says is good" as to say "I will commit to the CRSP U.S. Total Market Index."

Anyway, if all this were true, then the rational thing would be to look for a respected, large, plain-vanilla actively managed fund that seemed to have very low costs. Not a Sequoia with a 1.07% ER, maybe not even a Contrafund with an 0.68% ER, but there are starting to be "name brand" active funds with ERs under 0.50, particularly in "institutional" share classes available in 401(k) plans--it looks like American Growth Fund of America has an "R2" share class with an 0.44% ER, dunno anything about it. Of course we all know a company that has a lot of active funds with expense ratios in 0.3 territory.

In other words, my devil's-advocate argument for active is that "the ordinary competent managers do add maybe 0.50%, 0.60%, 0.70% alpha. Of course we all get the benefit because, through their wisdom, they help steer the great ship of capitalism by allocating resources to the most efficient companies. But the people in front of the ship benefit a little more from it than people like me willing to stand in the middle. So if you can find a fund that isn't likely to do anything too stupid, and that has an expense ratio so low that you can believe that they really are sharing some of their alpha with you, and if you are willing and able to commit to staying the course in it... you can't prove that anything else is better." And, who knows? Largely due to Vanguard's price pressure, maybe the market is wising up and is slowly forcing active manager to share some of their alpha with the customers.
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Re: Best argument you've heard against passive/for active?

Post by JoMoney » Tue May 16, 2017 7:56 am

nisiprius wrote:... there seems to be decent evidence that actively managed mutual funds... or do we have to add "the usual ones sane people would invest in????" actually do beat the market before fees, but by amounts that are very small. ...

According to the 2016 Year-end SPIVA score card
Over the prior 15 years,
All Domestic Funds (Equal-Weighted) returned 6.15%
All Domestic Funds (Asset-Weighted) returned 6.39%

I point this out, because I think it's interesting that because the average return of funds equal-weighted are lower than the average of asset-weighted holdings of all funds implies that most funds perform even worse, but the ones people actually put the most money in are slightly better.
I think I've heard Mr. Bogle comment on this as being evidence that people are paying attention and investing more in lower cost funds, which are on average certain to return more than the average high cost fund.

It's a poor consolation considering the S&P 1500 index returned 7.06% over the period, but maybe... just maybe... people are able to select slightly better active funds relative to each other.... but it could also be highly skewed where it's a small number of people who control substantial amounts of money that are able to pick the slightly better active funds.
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Re: Best argument you've heard against passive/for active?

Post by KlangFool » Tue May 16, 2017 8:48 am

nura wrote:
stlutz wrote:
what are the most convincing arguments people have heard against passive investing or in favor of active investing?


Vanguard Wellington

+1, actively managed Wellington has beat it's passive counterpart balanced index, inclusive of expenses since the latter's inception while holding less than 10% of the securities found in the index.


+1.

KlangFool

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Re: Best argument you've heard against passive/for active?

Post by avalpert » Tue May 16, 2017 8:59 am

KlangFool wrote:
nura wrote:
stlutz wrote:
what are the most convincing arguments people have heard against passive investing or in favor of active investing?


Vanguard Wellington

+1, actively managed Wellington has beat it's passive counterpart balanced index, inclusive of expenses since the latter's inception while holding less than 10% of the securities found in the index.


+1.

KlangFool


I don't think Wellington is a good example for active funds - I think it is a good argument for value and term risk exposure. I'm pretty sure when you control for that alpha is near zero and may even be slightly negative.

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Re: Best argument you've heard against passive/for active?

Post by Buffetologist » Tue May 16, 2017 9:01 am

corrected my earlier post to make sense.

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Re: Best argument you've heard against passive/for active?

Post by KlangFool » Tue May 16, 2017 9:12 am

avalpert wrote:
KlangFool wrote:
nura wrote:
stlutz wrote:
what are the most convincing arguments people have heard against passive investing or in favor of active investing?


Vanguard Wellington

+1, actively managed Wellington has beat it's passive counterpart balanced index, inclusive of expenses since the latter's inception while holding less than 10% of the securities found in the index.


+1.

KlangFool


I don't think Wellington is a good example for active funds - I think it is a good argument for value and term risk exposure. I'm pretty sure when you control for that alpha is near zero and may even be slightly negative.


avalpert,

1) Wellington is an active fund. I do not think you would argue against that.

2) Wellington is low-cost. I do not think you would argue against that either.

<< I'm pretty sure when you control for that alpha is near zero and may even be slightly negative.>>

3) Now, as for whether Wellington outperformed its passive peers, I do not know. In my opinion, it is close enough that it does not matter to me.

KlangFool

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Re: Best argument you've heard against passive/for active?

Post by TheTimeLord » Tue May 16, 2017 9:17 am

Personally, I think the real argument isn't between active vs. passive per se. The argument is about cost and if active funds can justify their higher ER through greater returns. I am not sure passive has a real advantage if costs are essentially equal, or disadvantage. It isn't talked about that much here but the reality is an active funds with holding a couple hundred stocks is essentially a closet index funds and cap weighted indexes with companies like Apple, Google and Microsoft in them aren't as diverse as the number of holdings suggest so basically it comes down to ERs.
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Re: Best argument you've heard against passive/for active?

Post by Independent George » Tue May 16, 2017 9:34 am

Theoretical argument, or practical?

The theoretical argument (which has some truth to it) is that an active fund can swim against the herd and and "buy cheap" when there's a lot of money flowing out, or re-balance when one sector out-performs. In practice, most active funds do this tend to be worse than someone re-balancing their index fund portfolio on their own.

The practical argument typically involves saying that 'X' fund has beaten the S&P over 'Y' years. This is almost always true - there will always be some number of funds that beat a portfolio of Index funds over some time period. The problem starts with the old disclaimer, 'past performance does not guarantee future results'. Somebody is always going to beat the market over a given period - they are rare, though, and it is near impossible to identify who they are (and for what period they will beat the market) in advance.

I think you can make the case that for people who don't know their own risk tolerance, or do not know truly understand diversification and asset allocation, a good mutual fund can do the work for them. Of course, the problem there is that the same people who don't know enough to pick their own asset allocation instead have to pick the people to manage it, and are making a decision with much less transparent information than just looking at the allocations in a Target Date fund.

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Re: Best argument you've heard against passive/for active?

Post by AllieTB1323 » Tue May 16, 2017 9:41 am

KSOC wrote:
MrFlish wrote:
stlutz wrote:
what are the most convincing arguments people have heard against passive investing or in favor of active investing?


Vanguard Wellington



+1


Wife & I hold Wellington & Wellesley in our TIRAs. With those track records & ER's it feels kinda wrong to call them active. :happy



Ditto, DW and I have held Wellington in our IRAs for decades.

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Re: Best argument you've heard against passive/for active?

Post by tup45678 » Tue May 16, 2017 10:03 am

I think the best argument against passive investing isn't about the past or present where the evidence shows that passive is clearly the superior choice, but rather about the future prospects given the results of the shift we're seeing as people pile into passive strategies and abandon their under-performing active managers. The history of the performance of strategies that experience a surge of inflows like Vanguard and other passive managers are now has not been pretty.

The active management industry is currently way too bloated and has been charging money for an inferior product. The shift we're seeing now away from active managers makes sense is both causing the active management industry to contract and putting pressure on the remaining players to reduce fees. I don't think the active management industry is incapable of producing alpha generally, just that the active management industry as currently constituted (way too many players and high fees). The market I think will restore more of an equilibrium going forward such that active managers as a whole will continue to under-perform less and less with more funds showing evidence of out-performance until the choice between active and passive becomes less clear.

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Re: Best argument you've heard against passive/for active?

Post by mcxavierdaniel » Tue May 16, 2017 10:05 am

Theory vs Practical: Would anyone choose the VG Primecap fund over an equity index fund holding the same segment (lg growth) if they had the option? The expense ratio is 0.35% vs an obviously much smaller expense ratio for an index fund. But, Primecap's performance has been stellar over the long-term and the after-expense returns seem to far outweigh an index fund holding the same market segment. Unless I'm not thinking about it correctly, the index fund would have to return close to 2% more to make it equivalent. Primecap is closed, but I was fortunate enough to get into it over 15 yrs ago and it's about 35% of my retirement portfolio. I waver over the active vs passive mgmt allocation in my portfolio, but in the end decide it doesn't apply to Primecap and does apply to virtually every other mutual fund out there.

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Re: Best argument you've heard against passive/for active?

Post by Leif » Tue May 16, 2017 10:35 am

Vanguard's Capital Opportunity fund, WHCAX. Of course a single fund is not a good argument for an entire class. You might call it cherry picking. But to me it is personal.

I had this fund back in 2000. At that time I had Vanguard do a portfolio analysis for me. They suggested I sell this fund. As I wanted to move to index funds I did so.

Capital Opportunity is considered Large Growth by M*. Since 2000 at $10,000 investment is now worth (from M*, rounded to nearest $100):
Capital Opportunity..$47,000
Vanguard Total Mkt..$24,700
S&P 500................$22,900
Large Growth.........$16,400

However, my conclusion is there really is no good argument for active funds. Low cost, highly diversified Index funds is the way to go. It is really a dead issue.

I wonder about janeway, with 7 posts, motivation. I hope we don't see an article titled "Bogleheads reasons for going active".
Last edited by Leif on Tue May 16, 2017 7:13 pm, edited 2 times in total.
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Re: Best argument you've heard against passive/for active?

Post by Lauren Vignec » Tue May 16, 2017 11:49 am

I've not heard any good arguments against passive management. I have heard two good arguments for active management.

First, some asset classes are hard or impossible for a retail investor to get through passive funds. Second, the Wellington fund is a good example of the fact that, for many people, an active manager does a better job of selecting an essentially passive portfolio than the investor would do if they put together their own passive portfolio. When I say "essentially passive" I just mean that Wellington has low costs, low turnover and its returns are explained by factor exposure.

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Re: Best argument you've heard against passive/for active?

Post by whodidntante » Tue May 16, 2017 11:54 am

venkman wrote:
janeway wrote:As an example, I read an argument that with index investing you guarantee less than average returns because the fees, while low, are non-zero.


Indexing guarantees your return will be slightly less than the index return. But that's irrelevant, because no one can invest directly in an index.



Securities lending revenue can create a negative effective ER.

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Re: Best argument you've heard against passive/for active?

Post by whodidntante » Tue May 16, 2017 11:57 am

There is a clear benefit to patient trading for some securities versus blindly following an index.

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Re: Best argument you've heard against passive/for active?

Post by JoMoney » Tue May 16, 2017 12:38 pm

whodidntante wrote:There is a clear benefit to patient trading for some securities versus blindly following an index.

Personally, I don't like the idea of a mutual fund playing games with holdings based on perceived temporary liquidity issues, and hoping they can do better if they're "patient" with their trading. If the opportunity doesn't show up before others who own the fund want to sell or buy more of the fund it can create issues where people who don't get out early are left holding a bag of increasingly more risky/illiquid securities, or new investors buying in are getting a free ride diluting whatever value the 'patient trading' achieved. It's not really an issue with the highly liquid large cap stock funds, but I would be concerned if I was holding a junk bond fund. I like that an index fund tracks an index, and all the investors will get that result, and can verify the fund is tracking it's objective.
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Re: Best argument you've heard against passive/for active?

Post by DartThrower » Tue May 16, 2017 1:24 pm

I am stunned that no one has yet mentioned the Oracle. Just find someone with a 180 IQ and with the drive, temperament, investing acumen and integrity to provide you with out-sized returns.

For my part I forego the search and settle for index funds. But keep in mind that it's not just about low cost investing, it's also about several other very important principals of constructing a sensible investment plan and then executing on that plan over the course of a lifetime. This ties in with the question of whether the Great Migration to index funds is a fad or a permanent phenomenon. Are those investors coming over to low cost investing also embracing common sense and discipline? If so then I say that it's not possible to have a bubble in common sense investing. This will not be a fad but rather a consequence of a better educated investing public. It will be an enduring advantage to the investing public and a permanent reduction to funds available to the croupiers.

I feel that good investing practice is getting lost in the media's coverage of the rush to passive funds. It's not just about that.
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Re: Best argument you've heard against passive/for active?

Post by ANC » Tue May 16, 2017 1:57 pm

1. Asset allocation. Most of the argument I have seen about passive vs. active concern what I call "point funds" and do not address the entire portfolio. We are in the T Rowe Price advisory program and hold a portfolio resembling their retirement and personal strategy funds, but with fewer funds and two passive ETFs in taxable. (We would hold all in an asset allocation fund were in not for a relatively large taxable account.) Constructing an asset allocation fund is inherently an active process and TRP has not made the missteps here that Vanguard has.

2. As a former owner of DVJ and DBC, I find that I am not as good at picking passive funds as at active funds--contrary to a view frequently expressed on this forum.

3. The areas where active funds have held their own against passive (investment grade bonds, developed international stock, and small cap growth) make up nearly 50% of our portfolio.

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Re: Best argument you've heard against passive/for active?

Post by boglephreak » Tue May 16, 2017 2:53 pm

i think the best argument for passive vs. active is that every year some active funds beat the market, so passive investing is not maxing your investment potential. there is only a small little problem with investing in active though: how do you pick those active funds beforehand and when do you get out of them as its not always the same active funds that beat the market each year?

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Re: Best argument you've heard against passive/for active?

Post by ruralavalon » Tue May 16, 2017 3:24 pm

KlangFool wrote:
nura wrote:
stlutz wrote:
what are the most convincing arguments people have heard against passive investing or in favor of active investing?


Vanguard Wellington

+1, actively managed Wellington has beat it's passive counterpart balanced index, inclusive of expenses since the latter's inception while holding less than 10% of the securities found in the index.


+1.

KlangFool

And other diversified, low expense ratio, low turnover managed funds. They are not passive but are hardly "active".
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Re: Best argument you've heard against passive/for active?

Post by mrc » Tue May 16, 2017 3:41 pm

Strongest argument against passive, for active?

One of them is T. Rowe Price's Approach to Active Management page

Key Points:

* 16 of our 18 diversified active U.S. equity mutual funds had positive hit rates over rolling five-year periods.
* A notable 89% of funds generated positive excess returns over both rolling 5- and 10-year periods.
* T. Rowe Price’s outperformance has tended to strengthen over time.


Those years the S&P, TSM, or TBM fell, and my account(s) lost money, I didn't pay nearly as much in fees for my index holdings as those invested in T. Rowe active funds did for the same privilege. I'm not sure when the markets went up if they were up enough to compensate for the higher expenses. I think it's closer with houses like T. Rowe than full-cost (1.5%+) funds. I've never done the back test for a low cost three-fund portfolio with Vanguard/TSP/Fido vs T. Rowe, mostly because I'm still a little unsure what all the knobs are. Seems if I pick exact three-fund analogs, and the T. Rowe ERs are higher, an indexer does better. Seems I can tilt, but that increases risk -- and I don't know which of the active funds will beat their respective index over the next n+1 years.

In short, I've not seen an argument against passive from a source I really trust, and that will guarantee future performance.
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Re: Best argument you've heard against passive/for active?

Post by TomatoTomahto » Tue May 16, 2017 4:01 pm

mcxavierdaniel wrote:Theory vs Practical: Would anyone choose the VG Primecap fund over an equity index fund holding the same segment (lg growth) if they had the option? The expense ratio is 0.35% vs an obviously much smaller expense ratio for an index fund. But, Primecap's performance has been stellar over the long-term and the after-expense returns seem to far outweigh an index fund holding the same market segment. Unless I'm not thinking about it correctly, the index fund would have to return close to 2% more to make it equivalent. Primecap is closed, but I was fortunate enough to get into it over 15 yrs ago and it's about 35% of my retirement portfolio. I waver over the active vs passive mgmt allocation in my portfolio, but in the end decide it doesn't apply to Primecap and does apply to virtually every other mutual fund out there.

Every year, we put the maximum allowed into PRIMECAP. It has done well, even after fees. $25k per account, and we have a good number of eligible accounts. Our son, for example, got grandfathered in (well, father and mothered in) and puts $5500 PRIMECAP in his Roth and $25k in his taxable account (i.e., just about every nickel he gets from his internships and campus jobs).

That's our only active fund, save one remaining share of BRK.A.

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Re: Best argument you've heard against passive/for active?

Post by JonnyDVM » Tue May 16, 2017 4:02 pm

The best argument is that many active funds beat the index and investors make more money than they would by indexing. If you just figure out which are the right active funds, you can make more money than you would by indexing. Sometimes a lot more money.
Last edited by JonnyDVM on Tue May 16, 2017 4:02 pm, edited 1 time in total.
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Re: Best argument you've heard against passive/for active?

Post by rattlenap » Tue May 16, 2017 4:02 pm

I've been catching the elevator at work over the last couple of months. On the small news monitors in them, I've been seeing advertisements from Oppenheimer funds with catchphrases like "Index Investing is so 1957" & "Market-cap weighting is so three martini lunch". Challenge the index!

Yeah, I guess the influx of people into index funds over the last several years has active manager's scared.

here's a link to their brokerage firm advertising this.

https://www.oppenheimerfunds.com/adviso ... -the-index

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Re: Best argument you've heard against passive/for active?

Post by rrscha22 » Tue May 16, 2017 9:29 pm

I remember a finance class in college that made the arguments this way--
Argument for Passive
If you look at the amount of information available on large, publicly traded companies and consider that extremely large companies may have an analyst or even a couple of analysts whose job it is to know everything about their particular company, you'd be silly to think that you (or a fund manager) know something that isn't already baked into the price, so you might as well go with the index.
Argument for Active
But if you consider your own local real estate market, could you find a deal in your area that would be better than the average houses in your market. It is possible because not as many people are looking at your local market and so much of the value is related to the local conditions. The same argument could be made for areas in the stock market where information isn't readily available--like emerging markets, small cap, or even micro cap funds. In those cases it is possible that someone could get additional information that everyone doesn't have to make better decisions. (In fact if a company is small enough, a giant investment could influence the trajectory of a company.) If you think you can get that information or have that kind of influence (or can identify someone who can--like a fund manager), then you have an argument for active management. If you don't think you can, then you know what the rest of the world knows, so you should index.

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Re: Best argument you've heard against passive/for active?

Post by BogleAlltheWay » Tue May 16, 2017 9:52 pm

Some arguments I have heard that I am unsure to agree with:

As more money flows into passive, good active managers will be able pick out bargains.
When a stock(s) goes in or out of the S & P, from emerging to developed etc. Index funds are forced to buy at a premium
ie. If they announce that Twitter is moving into the S and P active managers can buy the funds ahead of time before the price rises
Over-weighting of "hot stocks"
Larger stocks stocks overweighted: ie the S&P 500 is top heavy.
Active managers can take advantage in ninche markets

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CABob
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Re: Best argument you've heard against passive/for active?

Post by CABob » Tue May 16, 2017 10:00 pm

I'm not sure it is the best argument, but perhaps the first I read that got me going in the right direction was William Sharpe's 1991 paper.
Bob

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Re: Best argument you've heard against passive/for active?

Post by lack_ey » Tue May 16, 2017 10:29 pm

The better arguments are in fixed income.


In equities, all the arguments about lower information in certain kinds of stocks (small caps, emerging markets, etc.) are fine but the empirical evidence doesn't show good active fund manager performance there. After all, costs are higher there, and to succeed you have to take performance from others. Nevertheless there are some plausible cases that investing in relatively low cost active equity funds from good firms with sufficient resources (and hopefully also the right incentives, with manager investment in their own fund being a good sign) may be more successful than not compared to index funds in the category, in tax-advantaged accounts.

Also with active equity funds you can avoid index frontrunning and in theory wait for better trade execution—in any case, it's possible, though most active funds probably don't achieve some advantage over index funds in that regard. For those who believe in factor investing or smart beta, a slightly active approach may be better than an index fund tracking a smart beta kind of index in a few ways, such as updating information more quickly and not relying on the index's quarterly or yearly reconstitution to tell you then to make your moves, having more flexibility regarding position sizing and managing trades, etc. These could help.


In fixed income, if nothing else, new issuance is a significant part of the market, prices are more flexible and less centralized, and the large institutional players can negotiate consessions to get slight discounts that the indexes will never see. Market cap weighting makes less sense and is probably less optimal here. And the indexes generally cover only the more liquid issues available and not the whole market; the active fund opportunity set is effectively larger, which all else equal is not a negative. Active funds can go for less liquid bonds for some of their holdings (and all else equal, get an illiquidity premium) while maintaining plenty of other more liquid bonds to handle redemptions, rather than sticking with only the kinds of bonds that would make the indexes.

Many active bond funds also are allowed to hedge or gain exposures via derivatives, which again expands the opportunity set. They can opportunistically engage in small tweaks like allocating to ride the steep part of the yield curve, bet on spreads when they are wider, and so on. And to some extent there might be some advantage from bottom-up analysis and bond picking.

Furthermore, a significant portion of the market is non-price sensitive, for example government entities buying Treasuries to stabilize currencies or affect yields. To the degree that these push pricing in a way that doesn't maximize risk/return, there may be opportunities to deviate somewhat to gain an edge.

There's also a chance to profit from the index funds and some other more constrained investors, as in equities. The one easy example is when investment-grade bonds get downgraded into junk (so-called "fallen angels"). The turnover as many investors have to jettison these positions generally depresses value beyond what is fair.


Obviously you'd still have to pick the right manager at the right cost, which is difficult.

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Re: Best argument you've heard against passive/for active?

Post by TD2626 » Tue May 16, 2017 10:47 pm

It is reasonable to say that active managers generate, say, 0.5% alpha per year before fees by profiting from market inefficiencies caused by uninformed retail investors performing active trading when they have no business doing so. Market timers have to loose money to someone.

If this is true, an active fund with less than a 0.5% expense ratio would be expected to beat the market very slightly. A 0.4% expense ratio would give you only 0.1% above the market.

A strategy of investing some money in a variety of low cost (i.e. Vanguard) active funds MAY provide a very slight, but real, advantage over the long run.

Investing in active funds with high expense ratios (1 or 2%) is to be avoided of course. It is only with very low expense ratio active funds that this issue may come into play.

Also - does the extra 0.1% or so a year matter? Well, yes... but not as much as almost everything else (savings rate, paying down debt, asset allocation, etc). I feel as though most people should just index for simplicity. Those who wish to tilt toward active should know what they are doing and why - and should only do it with a relatively small portion of their portfolio.

Interestingly, this theory suggests that picking the right manager doesn't matter much. Finding active funds with a sufficiently low expense ratio matters, instead. Indeed, having multiple active funds (all with expense ratios less than 0.5%) could tend to average out manager risk.

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Re: Best argument you've heard against passive/for active?

Post by sschullo » Tue May 16, 2017 11:10 pm

avalpert wrote:
KlangFool wrote:
nura wrote:
stlutz wrote:
what are the most convincing arguments people have heard against passive investing or in favor of active investing?


Vanguard Wellington

+1, actively managed Wellington has beat it's passive counterpart balanced index, inclusive of expenses since the latter's inception while holding less than 10% of the securities found in the index.


+1.

KlangFool


I don't think Wellington is a good example for active funds - I think it is a good argument for value and term risk exposure. I'm pretty sure when you control for that alpha is near zero and may even be slightly negative.


Exactly.
The active management aficionados often point to Wellington, but wellington is not out there to beat the averages. It is a large-cap value play and a balanced fund. There is no alpha when the managers only want to keep it that way. That's precisely why Wellington, and Wellesley, are fundamentally different from the so-called active managed fund universe, where I can imagine those hyperactive managers pick stocks like Jim Cramer.
Public School K-12 Educators: "Ask NOT what your annuity sales person can do for you, ask what you can do to be a Do-It-Yourselfer (DIY)."

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Re: Best argument you've heard against passive/for active?

Post by MrFlish » Wed May 17, 2017 5:28 am

sschullo wrote:
avalpert wrote:
KlangFool wrote:
nura wrote:
stlutz wrote:

"so-called active managed fund universe, where I can imagine those hyperactive managers pick stocks like Jim Cramer."



Ok...that made me laugh...

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Re: Best argument you've heard against passive/for active?

Post by sschullo » Wed May 17, 2017 6:14 am

MrFlish wrote:
sschullo wrote:
avalpert wrote:
KlangFool wrote:
nura wrote:



Ok...that made me laugh...
Well, even mentioning Jim C. makes anybody an amateur comedian. I love those buttons, and his diversification method is constructing a portfolio of four or five individual company stocks in different industries. I also love his morning "Mad Dash" escapade. Mad Money program ranks at the top for more than a decade. It's all about ratings and action of any kind works in our capitalistic system. What we do here cannot compete yet. Wait till Vanguard has 40-50 million clients when 60-70% of all Wall Street assets are in passive strategy, and perhaps the mainstream news will wonder what happened, and we do here, but not yet.
Public School K-12 Educators: "Ask NOT what your annuity sales person can do for you, ask what you can do to be a Do-It-Yourselfer (DIY)."

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Re: Best argument you've heard against passive/for active?

Post by IlliniDave » Wed May 17, 2017 9:35 am

I think active funds with the following two characteristics can make good investments:

-Low fees
-Low turnover

You could call the strategy long-term stock picking maybe.

As both of those characteristics decrease the fund approaches an index fund with a custom, in-house, index defined by it's portfolio. A de-facto index fund.

There is probably a sweet spot in the run-up to approaching a de-facto index. Some of Vanguard active funds operate in this area successfully as do some of the bond funds as well as the Capital Opportunity Fund, Wellington, etc. I'm sure other non-Vanguard funds succeed with this sort of recipe. For a stock fund it seems like ER < 0.5% and portfolio turnover averaging maybe 20% or less typify this.

I'm not a big fan of stock funds with high turnover. There may be good ones, but typically they have the highest management fees as well as the highest trading costs which puts them at a large disadvantage compared to more passively managed active funds and index funds.
Don't do something. Just stand there!

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Re: Best argument you've heard against passive/for active?

Post by hushpuppy » Wed May 17, 2017 11:48 am

IlliniDave wrote:

I think active funds with the following two characteristics can make good investments:

-Low fees
-Low turnover

You could call the strategy long-term stock picking maybe.

As both of those characteristics decrease the fund approaches an index fund with a custom, in-house, index defined by it's portfolio. A de-facto index fund.

There is probably a sweet spot in the run-up to approaching a de-facto index. Some of Vanguard active funds operate in this area successfully as do some of the bond funds as well as the Capital Opportunity Fund, Wellington, etc. I'm sure other non-Vanguard funds succeed with this sort of recipe. For a stock fund it seems like ER < 0.5% and portfolio turnover averaging maybe 20% or less typify this.

I'm not a big fan of stock funds with high turnover. There may be good ones, but typically they have the highest management fees as well as the highest trading costs which puts them at a large disadvantage compared to more passively managed active funds and index funds.
Don't do something. Just stand there!

********
Just to add, I believe a concentrated portfolio has a chance, however small, to outperform (not necessarily on a risk adjusted basis).

I personally do not think Warren Buffett, Todd Combs, Ted Weschler, Don Kilbride/Wellington (Dividend Growth), Primecap Management (Capital Opportunity), Jean Hynes/Wellington (Health Care) are doomed to failure. Interestingly at least to me, they all apparently agree that they are not doomed to failure. This is demonstrated not necessarily by their words, but by their actual engagement (and success?) as active managers. I really don't need to argue, as the returns I receive from Capital Opportunity and Health Care in particular far exceed a more diversified index like the total stock market. However, for those who abhor my selection of managers versus index funds only, I understand your aversion. :shock:

Regards,

hushpuppy

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Re: Best argument you've heard against passive/for active?

Post by Gropes & Ray » Thu May 18, 2017 8:10 am

I was explaining my investment strategy to a friend who is an investment manager. He looked at me a little shocked and said, "I have to make money too." I should have known not to talk about indexing around him and I felt guilty.

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Re: Best argument you've heard against passive/for active?

Post by wolf359 » Thu May 18, 2017 8:54 am

The best argument I've heard is:

If you're going to invest in an index fund, you're going to get market returns. The only chance you have of beating the market is to invest in an active fund.

A variation:

If you invest in the market averages, you get average returns. Why are you settling for average? Pick a fund that's been beating the averages year after year for the past 10-15 years.

These arguments get used over and over by the fund salespeople because they work. They're pithy, and they speak to a human need to be better than average. I'm not saying that these arguments aren't flawed, but my arguments about why they're flawed are pointless if I'm arguing them to a salesperson. I'm not going to convince them, because they're selling something. (They're trying to get YOU to buy their stuff. They may already be using index funds themselves.) It also takes a lot of detail to explain why these arguments are flawed when I'm telling friends and family (after they've already bought in.)

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Re: Best argument you've heard against passive/for active?

Post by Lobster » Fri May 19, 2017 10:25 am

janeway wrote: I'm therefore curious what are the most convincing arguments people have heard against passive investing or in favor of active investing?


Arguments that work (but are not sound):
  • You need a professional to manage this very complicated world of finance. Look at this chart that compares the 'index' to our mutual fund blend (after expenses). As you can see, our blend blows the index out of the water. Doing something basic like an index fund is okay, but with us you will do much better, as demonstrated by this chart.
  • Index funds are unsophisticated and therefore can never expect to do better than average. We will build a custom portfolio for you based on our firm's 100 year history that will do much better than indexing***
Rebuttal
  • A comparable blend of index funds covering the same factors as the advisors' blend will have done better by precisely the difference in fees. An apples to apples comparison will demonstrate how poorly the active funds have done
  • The return of active funds in aggregate must be the total market return minus fees. It is mathematically impossible for active funds as a group to generate alpha. The entire system has negative alpha that is exactly the amount they take in fees (maybe ~2% for ER + hidden expenses). This means as a whole all of the active funds are losers. At any one moment in time a particular fund may be outperforming, but this can always be explained by a currently hot sector (rather than the active managers stock picking prowess). The track record of managers being able to get in and out of hot sectors repeatedly is very poor. Instead, active funds get spun up by the hundreds. The handful that happen to outperform in the short term are used to sell people on active management, and when the hot sectors mean revert the fund loses its advantage and quietly get closed down while the next new hot fund is being pushed.

Legitimate Argument (Something closer to what fee-only advisors might suggest):
  • The track record of the average investor is very poor, a recent 2016 study demonstrates that investors generally underperform the market by ~3%. This is caused largely by having an unsuitable asset allocation, and behavioral mistakes such as chasing after performance by selling low and buying high. Working with a professional will build a sound strategy and help prevent panic moves that will devastate long term returns.

This argument is fairly compelling to me for individuals who aren't interested in doing sufficient research to DIY, or are prone to making behavioral mistakes (it takes a lot of self-awareness for someone to admit this to themselves). My advice for people in this category is to stick with an index based target date fund, or use a low cost robo-advisor. For individuals with more complicated situations, using a professional whose fees are easy to understand and will not erode a substantial amount of the portfolio value over time is a sensible plan.
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