Proponents of low-cost investing are sometimes ‘challenged’ by proponents of actively-managed products and strategies. I use the quotation marks for two reasons: the first is that people on the other side of the debate are often eager to engage in intellectual jousting and second is that their logic itself is often, well…. challenging.
The intellectual jousting part is often stimulating. It consists of two primary considerations: facts and opinions. Once facts are established and agreed to, the question becomes one of what one might reasonably do (or counsel others to do) in a world where nothing is categorically certain. That’s when things become challenging in the sense that they might be frustrating or difficult to resolve.
The logic behind the matter in question can be explained using a classroom metaphor. Imagine if a teacher (or college recruiter, or parent or student) said something like: “everyone in the class expects to get a mark above the class average”. That’s the way it is with active managers. I’ve never met one that admits to being below average at the outset, yet in all asset classes and over all statistically significant time horizons, the fact is that the majority lag their benchmark (“class average”).
As Garrison Keillor lampooned in Lake Wobegone, we can’t all be above average. It may be true that each individually expects to beat the class average, but it should be obvious that it is metaphysically impossible and could never actually happen.
To active adherents, investing is all about beating a benchmark with less focus on reaching retirement objectives. Interestingly, my clients don’t generally talk about beating benchmarks, either. Most of the people I talk to in my practice want me to help them to reach their retirement goals on reasonable terms. To them (and to me), it’s about managing costs, setting reasonable asset allocations and return assumptions and similar things that are generally more controllable. If you do those sorts of things consistently, you’re much more likely to reach your retirement goals, in my opinion.
The thing that I hear almost every time from the active management proponents is that they believe that it is reasonable to expect that:
- Many active managers will outperform a benchmark over time; and
- Even if there are only a few who outperform, those that do can be reliably identified in advance
The counterpoints (something that active proponents almost never mention) include the following:
- All investing is a zero-sum proposition before costs
- Since investing costs money, all investing is negative-sum after costs
- Whenever an active manager “adds value” through trading, the person he trades with (by definition also an active manager) “subtracts” an equal amount of value. You can’t have winners without losers
- As time horizons are extended, the probability of outperformance diminishes because the cumulative impact of costs increases.
- Using one’s investing lifetime (let’s say 50 years) as the most appropriate timeframe for investing and using multiple asset classes (let’s say 6) in portfolio construction, the likelihood of outperformance becomes increasingly remote, but never reaches zero.
The simple point here is that the expected return for any asset class is essentially the return of the benchmark minus the cost of the product that one buys to get access to that benchmark. There’s obviously a great deal of variance around those long-term, after-cost averages, but the simple causal impact of costs is frequently glossed over.
My question is: “how responsible is it to encourage someone to pursue a course of action where the probability of a positive outcome is less than an actionable alternative without also telling them about the alternative?” Whether the odds are one in 10 or one in a million, the point still holds that the risk of improbable outcomes needs to be clearly noted.
Here’s what I think we all should know:
- Both traditional active and traditional passive options have had their days in the sun
- There are other options (e.g. factor-based investing) that might also have merit
- Past performance cannot be relied upon when making investment decisions
- Cost is likely the most reliable predictor of future performance (and is negatively-correlated)
- There is essentially no chance that a passive option will outperform a benchmark – ever
- Passive options generally cost about 1% less than active ones
In the end, the decision about how to invest is up to the client. The industry simply has not done enough to ensure that there’s informed client consent about the options they need to be considering.
John De Goey is a portfolio manager with Industrial Alliance Securities Inc. and the author of The Professional Financial Advisor IV. Industrial Alliance Securities Inc. is a member of the Canadian Investor Protection Fund. The opinions expressed herein are those of Mr. De Goey alone and may not be aligned with the opinions and values of Industrial Alliance Securities Inc. or any of its affiliated companies.
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