Investing: The Active/Passive Debate

Mainly this is a brief (and hopefully apt) election of quotes about indexing versus active management.

The first quote is long --- and not particularly poetic --- but stay with me. To the prepared ear, it is lyrical.


"Third---and here's the most interesting and, probably, annoying part---I believe the best investment strategy for most investors is not to buy and sell stocks at all, but simply to allocate assets to low-cost passive funds.  I didn't use to believe this.  When I worked on Wall Street, it seemed absurd to think that the massive amount of energy, brainpower, and money expended on buying 'good' stocks and selling 'bad' ones was usually wasted (or worse).  In the years since leaving the business, however, I have examined the evidence, and I have been startled and disappointed to realize how conclusive it is." --- Henry Blodget, the most famous security analyst of the period now called the internet bubble, writing in his blog The Internet Outsider, (November 14, 2005).

Though he admitted no wrong doing, Blodget avoided jail time by paying a large fine and entering into a plea agreement that bars him from the security industry.

What Blodget came to reluctantly, some others have exploited as a vehicle their chase for beyond-the-norm returns.


Jack Meyer won a place among the planet's most successful investors for his part in tripling the Harvard Endowment Fund from $8 billion to $27 billion, and he doesn't mince words:

"Most people think they can find managers who can outperform, but most people are wrong. Eighty-five percent to ninety percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value. The investment business is a giant scam."

Well, hum ... shuffling of feet ... "giant scam" seems a little harsh. Nevertheless, one cannot communicate clearly unless one is willing to take a stand. Still, let's turn down the heat with the more technical observation that not all indices are created equal. In fact, some make for lead to remarkably bad index funds, especially for taxable investors.


"The S&P 500 is a well-structured index because it has relative low turnover and the low turnover leads to reasonable tax characteristics. But the Russell 2000, which consists of stocks ranked by market defined once a year, has ridiculous characteristics. The turnover is extraordinarily high. In a market that you expect will rise over time, it will have very poor tax consequences. It's very widespread and used a lot but ridiculously, poorly constructed." --- David Swensen, former manager of the Yale endowment, in an interview for WSJ-Online (September 6, 2005).

Incidentally, the scuttlebutt is that the straightforward predictability of shares that must enter or exit the Russell 2000 led to arbitrage games which captured rents that perhaps more properly belonged to the long-term holders of Russell 2000 index funds. Fortunately, the effectiveness of these games was substantially diminished after May 16, 2003 when the Vanguard Small-Cap Index Fund switched its benchmark to the MSCI US Small Cap Index for which the entry-exit process works more like that of the S&P 500 index. Still, if substantial assets accrue in Russell 2000 indexed ETFs ... let the games begin!

Much Older --- But Closely Related

"It's difficult to get someone to understand something when his salary depends on his not understanding it." --- Upton Sinclair, quoted by Jack Bogle when discussing the mutual fund industry's attitude toward indexed funds.

Yet the Center Holds

"Truth springs from argument amongst friends. --- David Hume, quoted in 2004 the Yale Endowment

The conversation about active vs passive investing is not over, or at least it is not over for the professional. The very possibility of efficiently priced securities depends on the research and analysis of firms and individuals whose subsequent market actions enforce the efficiency of the markets. Without the price discovery process driven by research oriented market participants, there would be no efficiency in pricing.