Active vs. Passive Investing

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Active vs. Passive Investing

Post by gbs » Sat Feb 24, 2007 4:12 pm

[contributions needed]

Given that the original conception of indexing was a derivation of the implications of efficient markets, a look at the evolution of the Efficient Markets Hypothesis will provide insight into the active/passive debate.

Efficient Markets Hypothesis by Andrew W. Lo

THE NEW PALGRAVE: A DICTIONARY OF ECONOMICS, L. Blume, S. Durlauf, eds., 2nd Edition, Palgrave Macmillan Ltd., 2007
The efficient markets hypothesis (EMH) maintains that market prices fully reflect all available information. Developed independently by Paul A. Samuelson and Eugene F. Fama in the 1960s, this idea has been applied extensively to theoretical models and empirical studies of financial securities prices, generating considerable controversy as well as fundamental insights into the price-discovery process. The most enduring critique comes from psychologists and behavioural economists who argue that the EMH is based on counterfactual assumptions regarding human behaviour, that is, rationality. Recent advances in evolutionary psychology and the cognitive neurosciences may be able to reconcile the EMH with behavioural anomalies.

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Index Fundamentalism Revisited

Post by Petrocelli » Sat Feb 24, 2007 5:42 pm

Ed Tower's Index Fundamentalism Revisited compares the returns of Vanguard's active and Index Funds.
Link: here

Additional Vanguard Perspectives on Active Management:

1. Active Equity Management: Examining the Differences Between Fundamental and Quantitative Strategies : by Vanguard Institutional Investors
• Active management offers the potential to outperform a market or market segment, as measured by an index benchmark.
• Strategies for active equity management can be characterized as either fundamental or quantitative. Fundamental strategies may result in portfolios with risk characteristics that differ markedly from those of the benchmark, while quantitative strategies tend to result in more benchmark oriented portfolios.
• Although the processes employed by fundamental and quantitative managers in selecting stocks differ, both types of strategy can add value if delivered effectively.

2.The Case for Structured Equity: An Active Quantitative Investment Strategy: by Vanguard Institutional Investors
A structured equity investment strategy combines market-level risk with the opportunity for above-market returns. The strategy’s defining characteristics—rigorous risk control and a disciplined, theoretically sound approach to stock selection—place it between pure indexing and active investment strategies and make it an attractive alternative to both. Although structured equity and indexing strategies share an emphasis on tracking error relative to a market benchmark, structured equity is nevertheless an active management strategy, with all of the risks and opportunities implied by an active approach.

contributed by Barry

Vanguard on Indexing:

1.The Case For Indexing by Christopher B. Philips, CFA
Frank J. Ambrosio, CFA, Vanguard Investment Counseling & Research
An index is a group of securities designed to represent a broad market or a portion of the broad market. By reflecting the performance of a particular market, an index provides investors with a benchmark for that market’s performance. Because indexes are, by definition, intended to mirror the market, they are constructed to be market-capitalization-weighted. An indexed investment strategy such as an index mutual fund or an index-based exchange traded fund (ETF) tracks the performance of an index by assembling a portfolio that invests in the same group of securities, or a sampling of the securities, that compose the index. By investing in a product designed to replicate the performance of a broad market such as the U.S. stock market, an investor can participate, at low cost, in the aggregate performance of that market at all times. By the same token, investing in products designed to replicate the performance of indexes with a narrower focus, such as European stocks or long-term bonds, allows an investor to participate in the purest exposure to a specific market segment within a low-cost framework. As a result of these features, indexing has gained in popularity over time. Estimates of index fund assets, including ETFs, are as high as $865 billion, or 15.6% of the $5.5 trillion U.S. stock and bond mutual fund industry.

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Post by simba » Sat Feb 24, 2007 6:59 pm

  1. Indexed Investing: A Prosaic Way to Beat the Average Investor
    By William F. Sharpe
    Summary: Indexed investing is a strategy designed to match a market, not beat it. Done properly, it can be cheap and tax-efficient. After costs and taxes, an indexed investor in a market can beat the average active investor. Many investment vehicles, both mutual funds and the more recently introduced exchange-traded funds, make it possible for individuals to invest some or all of their assets in indexed strategies. This talk elaborates on these points, describes some of the more attractive funds and shows how indexed investing can be used to help obtain a globally diversified portfolio.
  2. Active vs. Passive Management
    By Rex A. Sinquefield (DFA)
    Summary: The following paper is a transcript of Rex Sinquefield's opening statement in debate with Donald Yacktman at the Schwab Institutional conference in San Francisco, October 12, 1995.
  3. The Arithmetic of Active Management
    By William F. Sharpe
    Summary:The average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.
  4. Passive Versus Active Investment Management Strategies: Comparisons, Perspectives and the Relevance to Financial Advisors
    By Andrei Voicu
    Summary: Discussion of the differences between passive and active investment strategies. A discussion of investment selection using both passive and active strategies, addressing the advantages and disadvantages of both
  5. Improved Study Finds Index Management Usually Outperforms Active Management
    By Millicent Holmes
    Summary:This study seeks to improve in several ways upon previous studies examining the relative performance of index management versus active management. It concludes that index management outperforms active management in most asset classes.
    To make comparisons between index management and active management as accurate as possible, the study segregated funds by style and then compared funds of the same style. This "apples to apples" comparison is the most accurate methodology. Many other studies suffer from some level of benchmark mis-specification or "size bias," as they compare all actively managed funds, which include Large-, Mid-, Small-, and Micro-cap funds to a Large-Cap Blend index, the S&P 500.
  6. The Case for Active or Passive Investment Management
    Summary - Point / Counterpoint. Active Management - Stephen B. Timbers / Passive Management - Weston J Wellington
  7. Three Challenges of Investing
    By John C Bogle

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Evaluating Small-Cap Active Funds

Post by Barry Barnitz » Mon Apr 16, 2007 10:18 pm

1. Evaluating Small-Cap Active Funds

Joseph H. Davis, Ph.D., Glenn Sheay, CFA, Yesim Tokat, Ph.D., and Nelson Wicas, Ph.D., Vanguard Investment Counseling and Research

Executive summary
Conventional wisdom maintains that, compared with their large- and mid-cap counterparts, small-cap active equity managers are more likely to outperform their market segment. At first pass, this “inefficient small-cap market” argument is appealing since greater opportunities could arise from greater dispersion of small-cap stock returns, more gradual information flows, and less thorough coverage by stock analysts. Our research challenges this widely held belief on several fronts. We find that the typical small-cap fund’s outperformance is an artifact of a particular benchmarking methodology. When we correct for the mismatch between active funds and popular small-cap benchmarks, the typical small-cap fund’s outperformance disappears. We also examine a related belief; i.e., because the small-cap stock market is inefficient, it’s possible to identify skilled managers who will repeatedly exploit those inefficiencies and generate persistent outperformance in the future. We demonstrate for prospective investors that the historical outperformance of the typical small-cap manager is fleeting. Our analysis indicates that the probability that past winners will repeat in the future is equivalent to a coin toss before costs (the same odds as if one picked small-cap funds at random). After costs, of course, the odds are less than 50-50. A key portfolio implication of our research is that, contrary to the conventional wisdom, indexing is a powerful investment strategy in all market segments, including small-caps.
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Indexing Quotes

Post by Taylor Larimore » Tue Apr 17, 2007 10:49 am

What the experts say:

"A low-cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth." Warren Buffet

"Of the 355 equity funds in 1970, fully 233 of those funds have gone out of business. Only 24 oupaced the market by more than 1% a year. These are terrible odds." Jack Bogle (2007)

"Most investors would be better off in an index fund." Peter Lynch

"Only about one out of every four equity funds outperforms the stock market. That's why I'm a firm believer in the power of indexing." Charles Schwab

"Index funds are perhaps the most underrated stock funds in existence." "Mutual Funds for Dummies"

"The fund industry's dirty little secret: most actively managed funds never do as well as their benchmark." Arthur Levitt, Chairman, SEC

"Over the long-term the superiority of indexing is a mathematical certainty." Jason Zweig, senior writer for "Money"

"The media focuses on the temporarily winning active funds that score the more spectacular bull's eyes, not index funds that score every year and accumulate less flashy, but ultimately winning, scores." W. Scott Simon, author

"I love index funds." William Sharpe, Nobel Laurete

"Indexing is for winners only." Jane Bryant Quinn, author, syndicated columnist

"Most people should simply have index funds so they can keep their fees low and their taxes down." Jack Meyer, CEO, Harvard Management

"Four years ago I was a fan of index funds. Today I am a true believer." Jonathan Clements, senior writer, Wall Street Journal

"We find that on average, active management reduces a portfolio's returns and increases its volatility compared with a static index." Vanguard Investment Counseling & Research Analysis

"They're just not going to do it (beat the market). It's just not going to happen. Daniel Kahneman, Nobel Laureate

"I was not always an obnoxious indexing zealot. Ten years of believing in and selling active management strategies in the brokerage industry made me this way." Rick Ferri,CFA, author, financial adviser

"Active portfolio management thus tends to generate lower returns and higher taxes." John Haslem, author,

"Indexing virtually guarantees you superior performance. Bill Bernstein, author, financial adviser

"Index funds save on management and marketing expenses, reduce transacton costs, defer capital gain, and control risk--and in the process beat the vast majority of actively managed mutual funds." Good & Hermansen, authors

"In every asset class where they are available. Index! Four of five funds will fail to meet or beat an appropriate index." Frank Armstrong, author, financial adviser

"With an index fund--the certainty of keeping up with the market is a very worthwhile trade-off for the possibility of beating it. Jack Brennan, CEO Vanguard

"Searching through a list of 234 domestic equity funds that have survived for 20 years, only 31 did better than the Vanguard 500 Index. That means the odds are really, really poor that any of us will do better than a low-cost broad index fund." Scott Burns, syndicated columnist

"Choosing actively managed funds is the triumph of hope over reason and experience." Larry Swedroe. author, financial adviser.

"It's just not true that you can't beat the market. Every year about one-third do it. Of course, each year it is a different group." Robert Stovall, investment manager

"Giving up the futile pursuit of beating the market is the surest way to increase your investment efficiency and enhance your financial peace of mind." Ron Ross, author and adviser.

"It is basically impossible to beat the market." Prof. Eugene Fama

"Indexing is a marvelous technique, I wasn't a true believer, I was just an ignoramus. Now I am a convert. Indexing is an extraordinarily sophisticated thing to do." Douglas Dial, former CREF portfolio manager.

"Simple buy-and-hold index investing is one of the best, most efficient ways to grow your money. Michael Lebouf, Ph.D., author

"The best plan for most of us, is to commit to buying some index funds and do nothing else." Charles Ellis, author

"With the market beating 91% of surviving managers since the beginning of 1982, it looks pretty efficient to me." Bill Miller, portfolio manager

"We should just forget about choosing fund managers and settle for index funds to mimic the market." Pat Regnier, former Morningstar analyst.

"Because active and passive returns are equal before cost, and because active managers bear greater cost, it follows that the after-cost return from active management MUST be lower than that from passive management." Wm Sharpe, Nobel Laurete

"The most efficient way to diversify a stock portfolio is with a low fee index fund." Paul Samuelson, Nobel Laurete

"We find that on average, active management reduces a portfolio's returns and increases its volatility compared with a static index implementation of the portfolio's asset allocation policy." Vanguard study

"Buy and hold. Diversify. Put your money in Index Funds." Justin Fox, Fortune senior writer

"Index funds save on management and marketing expenses, reduce transaction costs, defer capital-gain, and control risk--and in the process, beat the vast majority of actively manage mutual funds." Good & Hermansen, authors

"You should switch all your investment in stocks to index funds as soon as possible, after giving proper consideration to any tax consequences." Chandan Sengupta, author.

"I am somewhat skeptical about anyone's ability to consistently beat the market." Moshe Milevsky, author

"With an index fund--the certainty of keeping up with the market is a very worthwhile trade-off for the possibility of beating it." Jack Brennan, Vanguard CEO

"With a very simple and basic understanding of index funds, you can consistently beat 70% to 80% of all professionally managed index funds." Tweddell & Pierce, authors.

"Invest in a stock index mutual fund. What a brilliant, ingenious, common sense idea that I can't take credit for, but can religiously pass along to those of you who want to unclutter your financial lives and own a sophisticated portfolio." Bill Schultheis, author

"For most of us, trying to beat the market leads to disastrous results." Prof. Jeremy Siegel, author

"The surest way to make money in the stock market is not to work very hard at it. Don't try to outsmart the market; settle for matching it. Put most of your money in an index mutual fund." Gary Belsky, author

"My strongest commitment in the mutual fund arena is to index funds." Richard Young, editor

"I recommend that the long-term buy-and-hold portion of your equity portfolio be invested in equity mutual funds." Sheldon Jacobs, author

"The smartest thing people can do if they want money in the equities market is buy an index fund that is run for 30 basis points a year and forget about it." Elliot Spitzer, NY Attorney General

"The only consistent superior performer is the market itself and the only way to capture the superior consistency is to invest in a properly diversified portfolio of index funds." Rex Sinquefield, researcher.

"It's extremely difficult to beat the market." Peter Brimlow, Forbes senior editor

"There can be no question that indexing for most categories of taxable invesor and for most marketable conditions, will outperform conventional active management." Robert Arnott, CEO First Quadrant

"A passive index fund managed by a not-for-profit investment management organization represents the combination most likely to satisfy investor aspirations." David Swensen, author

"The S&P index benchmarks outperformed their active peer funds in all nine Morningstar style boxes over the past ten years." Gus Sauter (1-25-05)

"It's amazing to me that, by one estimate, only 14% of money is indexed in this country!! What a shame." Lynn O'Shaughnessy, author

"I continue to believe that unless you are extremely skilled (and lucky) for most investors, index funds remain the simplest and most efficient vehicle for investing in stocks." Annette Thou, author

"When you realize how few advisors have beaten the market over the last several decades, you may acquire the discipline to do something even better: become a long-term index fund investor." Mark Hulbert, newsletter tracker.

"Most investors should simply invest in index funds." Robert Rubin, Former Secretary of the Treasury

Best wishes.

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Post by alec » Tue Apr 17, 2007 12:03 pm

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Measuring Active Management:

Post by Barry Barnitz » Mon Jul 09, 2007 9:59 pm

1.) How Active is Your Fund Manager? a New Measure that Predicts Performance by Cremers, Martijn and Petajisto, Antti, (January 15, 2007)
To quantify active portfolio management, we introduce a new measure we label Active Share. It describes the share of portfolio holdings that differ from the portfolio's benchmark index. We show that to determine the type of active management for a portfolio, we need to measure it in two dimensions using both Active Share and tracking error. We apply this approach to the universe of all-equity mutual funds to characterize how much and what type of active management they practice. We test how active management is related to characteristics such as fund size, expenses, and turnover in the cross-section, and we look at the evolution of active management over time. We also test how active management is related to fund performance. The funds with the highest Active Share significantly outperform their benchmark indexes both before and after expenses, while the non-index funds with the lowest Active Share underperform. The most active stock pickers tend to create value for investors while factor bets and closet indexing tend to destroy value.

2.) Where do Alphas Come From?: A New Measure of the Value of Active Investment Management by Lo, Andrew W., (May 8, 2007)
The value of active investment management is traditionally measured by alpha, beta, tracking error, and the Sharpe and information ratios. These are essentially static characteristics of the marginal distributions of returns at a single point in time, and do not incorporate dynamic aspects of a manager's investment process. In this paper, I propose a new measure of the value of active investment management that captures both static and dynamic contributions of a portfolio manager's decisions. The measure is based on a decomposition of a portfolio's expected return into two distinct components: a static weighted-average of the individual securities' expected returns, and the sum of covariances between returns and portfolio weights. The former component measures the portion of the manager's expected return due to static investments in the underlying securities, while the latter component captures the forecast power implicit in the manager's dynamic investment choices. This measure can be computed for long-only investments, long/short portfolios, and asset allocation rules, and is particularly relevant for hedge-fund strategies where both components are significant contributors to their expected returns, but only one should garner the high fees that hedge funds typically charge. Several analytical and empirical examples are provided to illustrate the practical relevance of these new measures.

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80-90% study

Post by ttony » Mon Aug 24, 2009 1:17 am

Hi all - Regarding the statistics that passive investment strategies beat eighty to ninety percent of active managers over the long run.

Does anyone know the studies that these numbers are coming from?? Any references to white papers or specific studies?

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Re: 80-90% study

Post by CyberBob » Mon Aug 24, 2009 5:22 pm

ttony wrote:Hi all - Regarding the statistics that passive investment strategies beat eighty to ninety percent of active managers over the long run.

Does anyone know the studies that these numbers are coming from?? Any references to white papers or specific studies?

Check out the S&P index versus active (SPIVA) report. Here is the latest midyear 2009 scorecard..


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Post by ttony » Tue Aug 25, 2009 2:57 am

Hi Bob,

Thanks very much for the S&P scorecard. It's insightful - particularly the performances in the emerging markets and small cap - areas active managers (and some passive proponents) cling onto the idea of alpha.

I'm wondering where are the longer term studies. 1 year - anything can and will happen. But when people are looking at 30+ year time horizons, the 1, 3, and 5 year time frames are irrelevant. I need a long term study that supplied those eighty to ninety percent numbers. Any help greatly appreciated

And my apologies if I posted this in the wrong area...