From Gerd Kommer and Alexander Weis
Viewed from a helicopter perspective, there are actually only two basic forms of investing: “active” and “passive”. Most people automatically associate investing and wealth creation only with aspects that belong to active investing. Active investing is “what everyone does,” namely stock picking, market timing, or a mix of both.
Actively 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. The global market share of active investing - correctly calculated - is likely to be around 98% (Kommer, 2019). A passive investor does not want to beat the market, but rather invests in the entire market on a buy-and-hold basis using low-cost index funds or ETFs.
One of the reasons active investing has such a high market share is that it corresponds to a central feature 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 investing, others are the market. Active investing feels normal, natural and obvious. Still, it comes with one big problem: it works pretty poorly.
A clear majority of all active investors - depending on the study, over 90% - are below 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 reflects the market or asset class on a buy-and-hold basis.
The minority of active investors who beat their passive benchmark for the time frame 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 for the future can be derived from the existence and composition of the minority. The scientific studies that have proven this over and over again and more convincingly for around 60 years are no longer countable.
The bottom line from 60 years of empirical financial market research: Probability-weighted, active investing is a loser's game.
The so-called Efficient Market Hypothesis (“EMH”) is usually cited as the reason for the better return-risk combination of passive investing. That is correct, but it falls short, because in addition to the EMH, there are actually several other causes and arguments that all combine to make passive investing the more profitable approach.
We would therefore like to use this blog post to present all the arguments that, taken together, ensure the superiority of passive investing.
Here are ten arguments why passive investing produces a better return-risk combination than active investing.
(1) The Efficient Market Hypothesis (“EMH”)
As mentioned above, it is the most commonly cited argument against active investing. The EMH states that security prices at any given time already incorporate all publicly available information; This information is already priced in. This is referred to as the information efficiency of capital markets (Brown, 2011). By using public information - most investors do not have any other information - it is not possible to achieve a reliable return advantage (in technical jargon, “alpha”) compared to the market average. In an information efficient market, the deviation from the market return for an individual investor is random. The American Nobel Prize winner in economics Eugene Fama is considered the “father” of the EMH.
(2) “The Arithmetic of Active Management” (AAI)
This term is the title of a famous essay by Nobel Prize winner in economics William Sharpe. The AAI says that the average active investor must, by mathematical necessity, underperform an equivalent passive investor (Sharpe, 1991). To put it a little 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 form the market. So – before costs – exactly half of it has to be better than the market and the other half is 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 underperform a passive investor on a “net” basis. This statement does not assume the validity of the EMH or any other conditions. Ultimately, it is based on very simple factual and market logic in connection 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 taxes, and active investors pay more taxes than passive investors. Why? Active investing, by definition, requires more buying and selling than passive investing, which is necessarily a buy-and-hold approach. Because the realization of price gains and the tax payment triggered by them is postponed into the future under buy-and-hold, it produces a so-called tax present value advantage compared to active investing (where this is not the case or less the case for the average position), i.e. the effective tax burden falls. This connection exists in virtually every tax regime. All other things being equal, this tax advantage of buy-and-hold becomes greater the higher the tax level. Under the German withholding tax regime, this effect leads to a net return increase of around one percentage point per year for stocks, all other things being equal, assuming a buy-and-hold period of 30 years (Kommer, 2018).
(4) Right skew in the return distribution for stocks
Right skew is a term from statistics and, to put it simply, means 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 of all, the right skew in the sense 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 entire market return above the money market interest rate (“risk-free return”) (Bessembinder, 2018). The other 96% “loser stocks” collectively only generate the “savings book return,” which, adjusted for inflation, is close to zero. Since the positive market return is ultimately concentrated in extremely few “superstar stocks”, it will be very difficult to identify them permanently and sufficiently reliably using stock picking. For a given time window - as mentioned above - only a small minority of stock pickers manage to do this and probably by chance. A completely different but similar “right skew phenomenon” exists in the longitudinal temporal section, i.e. the market returns per period (e.g. days, months or years) along the time axis. For example, if you missed the most profitable 20 months of the MSCI World Standard Index from the beginning of 1970 to the end of 2019 (50 years or 600 months) - that's only 3% of all months in these 50 years - the total return would shrink to 7.9% p.a. a. (nominal and in euros) fell drastically by half to 3.95% p.a. a. If you miss the best 49 months, i.e. just 8% of all months, the resulting return falls to zero over the entire 50 years. If this calculation were based on days instead of months, the return-destroying effect of missing small portions of the overall time period would be even more extreme. For “right-skewed reasons,” market timing must be unrealistically precise to be successful.
(5) “The Paradox of Dropouts”
According to this thesis of the economist Steven Thorley, the capital market (e.g. the global stock or bond market) is understood as a game with participants of different skills - a plausible assumption (Thorley, 1999). It is therefore obvious that over time it will mainly be players (market participants) with low skills who will leave the game because sooner or later they will notice 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 exceed 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 rather to a disadvantage.
(6) “The Paradox of Skill”
This thesis was originally formulated by the American biologist Stephen Jay Gould. It goes like this: It is assumed that the stock market is a competition whose outcome (the distribution of alpha among market participants, i.e. the excess or inferior return 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 training of investors and that this skill is gradually becoming more uniformly distributed 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 participants in the game, the influence of chance on the individual result increases. The higher the influence of chance, the less attractive active investing is.
(7) The Berk-Green alpha allocation hypothesis
The two economists Berk and Green showed in a highly acclaimed study in 2004 that in a market in which there are professional investors who can reliably generate alpha (i.e. a not-information-efficient market), this alpha does not flow to the providers of the investment capital, i.e. the investors, but is skimmed 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 mutual funds, hedge funds or asset managers) with a positive alpha increase their absolute fee income through the increasing volume of money under management and in some cases also through an increase in the percentage fee until the net return for investors has closely approximated the return of the market. This thesis can be easily reconciled with the observable data. So the Berk Green hypothesis says that even if real skill exists among market participants, it is not the end investors who will benefit.
(8) Tightening regulation
It is harder to beat the market in a tightly regulated 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 worldwide has increased significantly, especially in the last twelve years since the Great Financial Crisis of 2007 to 2009. Supervision has become stricter, more professional and prosecutions in the event of financial market offenses have become more effective. This development is likely to continue in the future. Just think of the drastically increased 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 means that over the long term more and more investors are observing and analyzing the market with ever better information and tools. Short-term “market anomalies” (mispriced securities, i.e. opportunities for additional returns) are therefore arbitrated away ever faster and more consistently, so that outperformance opportunities arise 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. One could also say, to simplify, by 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” – that is, all active investors – is increasing 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 of around 16%). The number of scientists studying financial markets has also been increasing for decades. Where wolves reproduce faster than lambs, there is less and less left for each individual wolf (Berkin & Swedroe, 2015).
Conclusion
We have shown that not only the Efficient Market Hypothesis - the information efficiency of the financial markets - is responsible for the statistically observable superiority of passive investing, but also nine other factors that are rarely mentioned in the financial media. What is particularly noteworthy from our point of view is that several of the anti-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 over the next few years.
literature
Berk, Jonathan; Green, Richard (2004): “Mutual fund flows and performance in rational markets”; In: Journal of Political Economy; 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; 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): Invest confidently with index funds and ETFs; Campus Verlag (5th ed.); Page 235 ff.
Kommer, Gerd (2019): “The ETF critics’ most important arguments – what’s wrong with them?” Lecture at the Federal Association of Consumer Advice Centers; https://gerd-kommer.de/medien/2019-01-VZBV-Kommer-V9-L.pdf
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; 47; #1.
Thorley, Steven (1999): “The Inefficient Market Argument for Passive Investing”; Internet reference: http://www.indexinvestor.co.za/index_files/theories_24.htm