The passive barbarian investors at the gate have changed the game

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Well, I won’t back down
No I won’t back down
You could stand me up at the gates of hell
But I won’t back down

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No I’ll stand my ground
Won’t be turned around
And I’ll keep this world from draggin’ me down
Gonna stand my ground
And I won’t back down ~ Tom Petty

There has been a major shift from actively managed funds into passive, index-tracking investments since 2008, with more than US$1 trillion flowing from actively managed U.S. equity funds into their passive counterparts, which have increased their share of the investment pie to more than 40 per cent from less than 20 per cent.

The theory underlying passive investing is the efficient-market hypothesis (EMH), which posits that markets are efficient, thereby causing asset prices to always be correctly priced. The theory contends that it is impossible to beat the market without assuming additional risk. Applied to the decision to hire an active manager rather than invest in a passive index fund, the EMH can be neatly summarized as “why bother?”

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It might seem that as an active manager, I am shooting myself in the foot by pointing out the success of passive investing at the expense of its active counterpart, but bear with me.

Not backing down: Bogle’s Folly

The first index funds were launched in the early 1970s and were only available to large pension plans. A few years later, the Vanguard First Index Investment Fund (now the Vanguard S&P 500 Index Fund) was launched as the first index fund available to individual investors. The fund was the brainchild of Vanguard Group Inc. founder Jack Bogle, who believed it would be difficult for actively managed mutual funds to outperform an index fund.

In its initial public offering, the fund brought in only US$11.3 million. Vanguard’s competitors referred to the fund as “Bogle’s Folly.” To the benefit of the investing public, he did not back down. Vanguard currently manages more than US$9 trillion in assets, the bulk of which is in index funds and exchange-traded funds.

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Approximately half of all assets managed by investment companies in the United States are now invested in Bogle’s Folly and its descendants.

At Berkshire Hathaway Inc.’s 2017 annual meeting, Warren Buffett estimated that by making low-cost index funds so popular for investors, Bogle “put tens and tens and tens of billions of dollars into their pockets.”

According to Buffett, “Jack did more for American investors as a whole than any individual I’ve known.”

The numbers don’t lie

In most cases, the long-term evidence makes it hard to strongly disagree with the EMH and, by extension, to advocate for active management over passive management.

According to S&P Global Inc., 78.7 per cent of U.S. active large-cap managers have underperformed the S&P 500 index over the five years ending Dec. 31, 2023.

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A US$10-million investment in the index made at the end of 2018 would have been worth US$20,724,263 five years later, compared to an average value for active managers of US$18,481,489, representing a shortfall of US$2,242,774 versus the index.

The Canadian experience has been similarly damning: 93 per cent of Canadian equity managers have underperformed the S&P/TSX composite index over the five years ending Dec. 31, 2023, according to S&P Global.

A $10-million investment in the index made at the end of 2018 would have been worth $17,079,526 five years later, compared to an average value of $15,217,594 for active managers, representing a shortfall of $1,861,932 versus the index.

Given these dire statistics, it is no wonder that there has been a massive migration from active to passive investing. Investors have been getting the message that the proclaimed advantages of active management are more hype than reality.

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Acceptable and unacceptable failure

“I can accept failure, everyone fails at something,” legendary basketball superstar Michael Jordan once said. “But I can’t accept not trying.”

Relatedly, within the sphere of active management, it is imperative to discern between what I refer to as sincere and disingenuous underperformers.

Sincere underperformers try their level best to outperform (an A-for-effort scenario). These active efforts entail expenses that passive funds do not face, such as paying investment professionals to analyze companies with the goal of identifying stocks that will outperform. These extra costs must be passed on to investors, resulting in higher fees than those for passive vehicles.

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In contrast, disingenuous underperformers are not truly trying to outperform. Their portfolios more or less replicate benchmark indexes. Such funds, which are pejoratively referred to as “closet indexers,” are charging active management fees for doing something that investors could do for a fraction of the cost by investing in an index fund or ETF — good work if you can find it.

An academic study — The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance — determined the pervasiveness of closet indexers across a sample of developed countries.

Of the 20 countries included in the study, Canada ranked highest in terms of its percentage of purportedly active mutual fund assets that are actually invested in closet index portfolios. Every year, such funds are unjustifiably charging investors billions of dollars in fees.

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Although the historical data clearly indicate that the vast majority of managers have underperformed their benchmarks, this is not universally the case. Although few and far between, there are managers who have managed to outperform, either in simple terms, in risk-adjusted terms or both, as our machine-learning based, algorithmically driven approach has done.

Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.

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