So thousands of published blog posts debating active versus passive and it turns out nobody was right (okay, maybe someone was right). That’s the latest from Michael Mauboussin’s “Looking for Easy Games”, on how the balance between active and passive impact each other. It’s your must read this week.
Mauboussin digs through the giant shift from active funds to passive funds over the past decade, its effect on markets, and, most important, how an investor subscribing to one (or the other) may benefit from an imbalance between the two.
The final driver of the shift from active to passive is at the heart of this discussion. Our point of departure is a paper by two economists, Sanford Grossman and Joseph Stiglitz, called “On the Impossibility of Informationally Efficient Markets.” The paper was published in 1980, which is noteworthy because the 1970s were probably the peak in enthusiasm for the efficient market hypothesis.
Their basic argument is that markets cannot be perfectly informationally efficient because there is a cost to gathering information and reflecting it in asset prices. Investors who absorb those costs should receive a proportionate benefit. That benefit comes in the form of excess returns as the result of inefficient prices.
This leads to a paradox: the more individuals who are informed, the more efficient prices become, and the less value there is in being informed. Efficient prices lead investors to move from active to passive, which may create inefficiencies from which active managers can profit. So if everybody invests actively, you want to be passive. If everyone invests passively, you want to be active. This is similar to the “El Farol Bar Problem” in game theory.
We believe that the drivers above, most notably technology, led to more efficient asset prices. As a result, in recent years the cost of active management outstripped the benefit in the Grossman-Stiglitz model. The move to passive reduces the amount that investors spend, bringing the cost-benefit balance closer to even.
We cannot have a world of passive investors only and we are not going back to all active managers. The problem is that the equilibrium is dynamic.
He goes on to cover how to find the right balance along with ways both active and passive can benefit from an imbalance. In time, I’m sure we’ll find that the balance between the two – the dynamic – moves with market cycles, but we’ll need a few more bull and bear markets to notice. Of course, any dramatic shift from the active side, due to tech and much lower fees, would interrupt that balance again.
One final highlight to think about:
One provocative idea is to start the investment process with a screen for potential inefficiency rather than, for example, cheap stocks.
- To Be a Great Investor, Worry More About Being Wrong Than Right – J. Zweig
- Grandmasters of Work – M. Housel
- 52 Key Learnings in 52 weeks of 2016 – The Mission
- 2016 Was Not a Particularly Volatile Year – AQR
- What History Tells Us about Your Investments in 2017 – B. Ritholtz
- Bond Fund Duration May Overstate Rate Sensitivity – Morningstar
- Michael Lewis Interview (video) – Charlie Rose
- How Amazon Innovates in Ways that Google and Apple Can’t – Vox
- Superintelligence: The Idea That Eats Smart People – Idle Words
- There’s a Massive Restaurant Industry Bubble About to Burst – Thrillist