Why the latest attack on passive investing is nonsense

By LARRY SWEDROE

The active investment management community has been attacking indexing — and passive investing in general — for decades. The reason is obvious: their profits (and for many firms, their very survival) are at stake.

The attacks began almost from the moment John Bogle started the First Index Investment Trust (later renamed the Vanguard 500 Index Fund) on December 31, 1975. At the time, competitors uniformly derided it, even calling it “un-American” and “Bogle’s folly”.

Now-retired Fidelity Investments Chairman Edward Johnson was quoted as saying he couldn’t “believe that the great mass of investors are going to be satisfied with receiving just average returns”. One of the great ironies is that Fidelity is now one of the leading providers of index funds. It was also the first fund family to offer a zero-expense-ratio index-based ETF.

The criticism reached an absurd level when a team at Bernstein called passive investing “worse than Marxism”. The authors of the note wrote: “A supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market led capital management.”

The latest attack on passive investing came in January 2020 from Michael Lebowitz, founding partner of 720 Global and partner at Real Investment Advice. In an article for Advisor Perspectives, Lebowitz declared: “Value investing is an active management strategy that considers company fundamentals and the valuation of securities to acquire that which is undervalued,” while “passive strategies are speculation, not investing.” Let’s consider an alternative viewpoint.

My view is that Lebowitz has this exactly backward, as the evidence will show. Active strategies are engaged in the speculation (a bet) that the market, in its collective wisdom, has somehow mispriced securities; in particular, the market has left value stocks underpriced. Let’s see why that doesn’t seem to be a logical conclusion.

Consider first that it is much easier for sophisticated arbitrageurs to correct undervaluation than overvaluation. The reason is that if sophisticated institutional investors or arbitrageurs thought stock A trading at 50 was worth 60, that would already be the price. Such investors don’t sit on their hands watching the screen and let bargains go by. On the other hand, if stock A is trading at 50 and the sophisticated investors thought it was only worth 40, that’s harder to correct because the investor must “short” the stock (borrow the stock they don’t own and then sell it, driving down the price) to correct the mispricing and benefit from it. And the risks and costs of shorting create what are referred to as “limits to arbitrage”:

Many institutional investors (such as pension plans, endowments and mutual funds) are prohibited by their charters from taking short positions.
The cost of borrowing a stock in order to short it can be expensive, and there can also be a limited supply of stocks available to borrow for the purpose of shorting. This can be especially true for small growth stocks.
Investors are unwilling to accept the risks of shorting because of the potential for unlimited losses. This is “prospect theory” at work, where the pain of a loss is much larger than the joy of an equal gain.
Short sellers run the risk that their borrowed securities are recalled before the strategy pays off. They also run the risk that the strategy performs poorly in the short run, triggering an early liquidation.

Taken together, these factors suggest that investors may be unwilling to trade against the overvaluation of securities, allowing overvaluation to persist more than underpricing.

Thus, we see that overvaluation is much more likely to persist than the undervaluation of value stocks Lebowitz is speculating on. That said, we now can turn to the evidence to determine if Lebowitz is right about active value investors. The S&P Dow Jones Mid-Year 2019 SPIVA (active versus passive) Scorecard shows that over the 15-year period ending June 2019, even before considering the impact of taxes, 80 percent of actively managed U.S. large value funds underperformed their benchmark. Even worse is that in the supposedly less efficient asset class of small-cap stocks, 87 percent of actively managed small value funds underperformed their respective benchmarks. Of course, after taxes the figures would be much higher because taxes are typically the highest cost of active management, greater than the trading costs and expense ratios of the funds.

Whose interests do they have at heart?

As American novelist Upton Sinclair wrote, “It is difficult to get a man to understand something, when his salary depends on his not understanding it.” The tidal wave that is the trend to indexing and passive investing in general has certainly created what could be called an existential threat to the active management industry — which explains why it has always railed against it, and will continue to do so, providing me with fodder for my cannon.

One final note. You’ll observe that while articles such as Lebowitz’s spin fanciful tales, they virtually never present any evidence to demonstrate that their story isn’t just another fairy tale.