By Gerd Kommer and Alexander Weis
From a helicopter perspective, there are actually only two basic forms of investing: “Active” and “passive”. Most people almost automatically associate investing and wealth creation only with aspects that are part of active investing. Active investing is “what everyone does”, namely stock picking, market timing or a mixture of both.
Active investing means investing money with the conscious or unconscious aim of making a particularly attractive investment compared to the relevant market or asset class. From the practical perspective of a private investor, this means either actively investing money yourself or commissioning a banker, asset manager or fund manager to do so for a fee. Correctly calculated, the global market share of active investing is likely to be around 98% (Kommer, 2019). A passive investor does not aim to beat the market, but invests in the market as a whole on a buy and hold basis, using low-cost index funds or ETFs.
One of the reasons why active investing has such a high market share is that it corresponds to a central basic characteristic of the human psyche that has been baked into our DNA by evolution over the last 10,000 years: Almost all of us want to be better than the others. When it comes to investing, the others are the market. Active investing feels normal, natural and self-evident. Nevertheless, it brings with it a major problem: It works pretty badly.
A clear majority of all active investors – over 90% depending on the study – underperform their passive benchmark for a given time window (e.g. the calendar year 2019, the last five years or the 20 years from 1970 to 1989), i.e. an index that is comparable from a scientific point of view and simply tracks the market or asset class on a buy and hold basis.
The minority of active investors who beat their passive benchmark for the time window in question probably did so by accident. This can be concluded quite reliably because this minority of outperformers will consist of other winners in the next equivalent time frame. Nothing can be deduced for the future from the existence and composition of the minority. The scientific studies that have repeatedly and convincingly proven this for around 60 years are no longer countable.
The quintessence of 60 years of empirical financial market research: On a probability-weighted basis, active investing is a losing game.
The so-called efficient market hypothesis (“EMH”) is usually cited as the reason for the better risk-return profile of passive investing. This is correct, but too short-sighted, because there are actually several other causes and arguments besides the EMH, all of which together make passive investing the more profitable approach.
We therefore want to use this blog post to present all the arguments that, taken together, make passive investing superior.
Here are ten arguments why passive investing generates a better risk-return profile than active investing.
(1) The efficient market hypothesis (“EMH”)
As mentioned above, it is the most frequently cited argument against active investing. The EMH states that security prices already contain all publicly available information at any given time; in other words, this information is already priced in. This is referred to as the information efficiency of capital markets (Brown, 2011). Using public information – the vast majority of investors do not have any other information – is therefore not a reliable way of achieving a performance advantage (known as “alpha” in technical jargon) over the market average. In an information-efficient market, the deviation from the market return for an individual investor is a coincidence. The American Nobel laureate in economics Eugene Fama is regarded as the “father” of the EMH.
(2) “The Arithmetic of Active Management” (AAI)
This term is the title of a famous essay by the Nobel Prize-winning economist William Sharpe. The AAI says that the average active investor must underperform an equivalent passive investor by mathematical necessity (Sharpe, 1991). To put it more precisely: At least 50% of all actively invested monetary units must have a worse return than a passively invested monetary unit. This is because all investors together make up the market. So – before costs – exactly one half must be better than the market and the other half worse. By definition, passive investors achieve exactly the market return before costs. Since the costs of active investors are necessarily higher than those of passive investors, more than half of active investors will “net” underperform a passive investor. This statement does not presuppose the validity of the EMH or any other conditions. Ultimately, it is based on very simple factual and market logic in conjunction with the five to ten times higher costs of active investing compared to passive investing.
(3) The built-in tax advantage of buy and hold
Almost all investors pay tax and active investors pay more tax than passive investors. Why? By definition, active investing requires more buying and selling than passive investing, which is necessarily a buy and hold approach. Because the realization of price gains and the resulting tax payment is postponed to the future under buy and hold, it produces a so-called tax present-value benefit compared to active investing (where this is not the case for the average position), i.e. the effective tax burden is reduced. This connection exists in practically every tax regime. All other things being equal, the higher the tax level, the greater the tax advantage of buy and hold. Under the German flat-rate withholding tax regime, this effect leads to a net return increase of around one percentage point per year for stocks under otherwise identical circumstances, assuming a 30-year buy and hold period (Kommer, 2018).
(4) Right skew in the return distribution for stocks
Right skew is a term used in statistics and means – in simple terms – that there are some extreme outliers very far “to the right” of the average. The phenomenon can be observed both in the “market cross section” and in the “longitudinal time section”. First, the right skew in terms of the market cross section: The market cross section is all stocks that exist or have existed in a certain period of time (e.g. 50 years). Here is the crux of the matter: Only 4% of all stocks are responsible for the total market return above the money market interest rate (“risk-free return”) (Bessembinder, 2018). The other 96% of “loser stocks” collectively generate only the “savings book return”, which is close to zero when adjusted for inflation. As the positive market return is ultimately concentrated in an extraordinarily small number of “superstar stocks”, it is likely to be very difficult to identify them permanently and with sufficient reliability using stock picking. As mentioned above, only a small minority of stock pickers succeed in doing this for a given time window, and probably by chance. A completely different but similar “right skew phenomenon” exists in the longitudinal time profile, i.e. the market returns per period (e.g. days, months or years) along the time axis. For example, if you miss the best 20 months of the MSCI World Standard Index from the beginning of 1970 to the end of 2019 (50 years or 600 months) – that is only 3% of all months in these 50 years – the total return of 7.9% p. a. (nominal and in euros) shrinks drastically by half to 3.95% p. a. If you miss the best 49 months, i.e. only 8% of all months, the resulting return over the entire 50 years falls to zero. If this calculation were based on days instead of months, the yield-destroying effect of missing out on small portions of the total time span would be even more extreme. For “right skew reasons”, market timing must therefore be unrealistically precise in order to be successful.
(5) “The Paradox of Dropouts”
According to this thesis by economist Steven Thorley, the capital market (e.g. the global stock or bond market) is understood as a game with participants of different abilities – a plausible assumption (Thorley, 1999). It is therefore obvious that, over time, it is mainly players (market participants) with low skill who will drop out of the game, as they will sooner or later realize their lack of success (return). As a result, the average skill level of the remaining players increases. It then becomes more difficult for a given remaining player to surpass the now higher average skill level (in the game “Stock Market” this is the market return). The paradox of dropouts implies that the increasing market share of passive investing in recent years (and in turn the decreasing market share of active investing) – contrary to what is often claimed – probably does not lead to an advantage for the remaining active investors, but to a disadvantage.
(6) “The Paradox of Skill”
This thesis was originally formulated by the American biologist Stephen Jay Gould. It works as follows: It is assumed that the stock market is a competition whose outcome (the distribution of alpha among market participants, i.e. the excess or shortfall in returns relative to the market average) is determined partly by skill and partly by chance. It is also assumed that the absolute skill level of market participants increases over time due to scientific and technical progress combined with better investor education and that this skill is at the same time gradually distributed more uniformly among market participants – the latter also because the proportion of private investors among all direct investors (Do-it-yourself investors) is actually falling (this has been proven for the US stock market). In such a context, the relative contribution of chance versus skill in determining the competitive outcome (the distribution of alpha among market participants) will increase over time because the skill of market participants is closer together (Mauboussin & Callahan, 2013). This phenomenon is a paradox, because despite the absolute increase in skill of most players, the influence of chance on the individual result increases. The greater the influence of chance, the less attractive active investing is.
(7) The Berk-Green hypothesis on the allocation of alpha
In 2004, the two economists Berk and Green showed in a much-noticed study that in a market in which there are professional investors who can reliably generate alpha (i.e. a non-information-efficient market), this alpha nevertheless does not flow to the providers of the investment capital, i.e. the investors, but is siphoned off by the owners of this skill (the investment managers) in the form of a correspondingly expanded fee income (Berk & Green, 2004). According to Berk and Green, successful investment managers (e.g. managers of retail funds, hedge funds or asset managers) with a positive alpha increase their absolute fee income via the increasing volume of money under management and in some cases also via an increase in the percentage fee until the net return for investors has come very close to the return of the market. This thesis can be easily reconciled with the observable data material. So the Berk-Green hypothesis says that even if real skill exists among market participants, it will not benefit end investors.
(8) Tightening of regulation
In a tightly regulated market, it is harder to beat the market than in a loosely regulated market. Regulation tends to contribute to the elimination of “special opportunities” for individual investors and to more equal opportunities for the mass of investors. In recent decades, the level of regulation in the financial markets has increased significantly worldwide, particularly in the last twelve years since the Great Financial Crisis from 2007 to 2009. Supervision has become stricter and more professional, and prosecution in the event of financial market offenses has become more effective. This trend is likely to continue in the future. Just think of the drastically intensified penalties in Western countries and the prosecution of insider trading, a historically important source of outperformance.
(9) Technical progress
The increasing spread and improvement of computer technology and the Internet mean that, over the long term, more and more investors are using better and better information and tools to monitor and analyze the market. Short-term “market anomalies” (mispriced securities, i.e. opportunities for excess returns) are therefore being arbitraged away ever more quickly and ever more consistently, so that outperformance opportunities occur less frequently. This technical progress will continue in the future.
(10) Limited alpha volume versus increasing number of alpha hunters
The pool of opportunities to achieve excess returns compared to the market (alpha pool) is ultimately limited by the global economy, i.e. the real economy. You could also simplify it by saying the number of companies and investment projects. The global economy is growing at around 3% per year over time. However, the number of “alpha hunters” – i.e. all active investors – is rising faster. One of many indicators of this is the increase in the number of hedge funds: In 2000 there were 900 worldwide, today there are 15,000 (an average annual growth rate of around 16%). The number of academics studying the financial markets has also been increasing for decades. Where wolves reproduce faster than lambs, there is less and less left for the individual wolf (Berkin & Swedroe, 2015).
Conclusion
We have shown that it is not only the efficient market hypothesis – the information efficiency of the financial markets – that is responsible for the statistically observable superiority of passive investing, but also nine other factors that are rarely mentioned in the financial media. In our view, it is particularly noteworthy that several of the contra-active arguments listed here are likely to increase in strength and impact in the future. To the extent that this is the case, it will further increase the relative attractiveness of passive investing in the coming years.
References
Berk, Jonathan; Green, Richard (2004): “Mutual fund flows and performance in rational markets”; In: Journal of Political Economy; Vol. 112; No. 4.
Berkin, Andrew; Swedroe, Larry (2015): “The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches”; Buckingham.
Bessembinder, Hendrik (2018): “Do Stocks Outperform Treasury Bills?”; In: Journal of Financial Economics; Vol. 129; No. 3.
Brown, Stephen (2011): “The efficient market hypothesis: The demise of the demon of chance;” In: Accounting and Finance; Vol. 51.
Kommer, Gerd (2018): Souverän Investieren mit Index Fonds und ETFs; Campus Verlag (5th ed. Ed.); page 235 ff.
Mauboussin, Michael; Callahan, Dan (2013): “Alpha and the Paradox of Skill”; Credit Suisse.
Sharpe, William (1991): “The Arithmetic of Active Management”; In: Financial Analysts Journal; Vol. 47; No. 1.
Thorley, Steven (1999): “The Inefficient Market Argument for Passive Investing”; Internet source: http://www.indexinvestor.co.za/index_files/theories_24.htm
