Investing is a zero sum game. The total excess (above average) market return (‘alpha’) available to all investors is exactly zero. That holds true for every asset class in every market. It does not matter how efficient those markets are, or how small, or how concentrated the aggregate alpha available to all investors is always zero.
Yes, some investors do earn an above-average return, but only at the expense of others earning a below-average return. But collectively, they all pursue something that does not exist. It is an expensive folly as both winners and losers forfeit their stake, in the form of high(er) active management fees. As a group, these investors go home with less than zero.
So do the passive investors, of course. But because they have abandoned the quest for alpha and simply pursue the market return at low cost, their forfeit is lower. They pocket a higher average return. In the words of Charles Ellis, they win the losers’ game. And it is a game worth winning: every 1% pa fee saving over a forty-year savings term improves the real (after-inflation) savings outcome by 30%!
Empirically, the great majority of fund managers underperform their benchmarks, after adjusting for fees and survivorship biases poorly performing funds merge with better performing funds so their poor performance is lost, which overstates the returns achieved by the remaining funds. And it is impossible to predict who will outperform. Certainly, no fund manager has yet guaranteed their outperformance.
In a recent article, Sanlam commented that National Treasury “puts great store on the validity of the efficient market hypothesis, in spite of it being largely disgraced during the recent financial crises”.
It is a compelling argument, that financial markets have price flaws and that active managers can exploit this. It implies that the ‘market’ is a separate, sometimes irrational being, apart from investors. But active investors are the market. It is they who trade against each other and who ‘discover’ prices, sometimes at irrationally high or low levels. If markets are inefficient, it is active investors who make it so.
Many market bubbles have burst over the last ten years the ideal time for active managers to prove their stock picking and market timing skills. Yet the majority lagged their indexing peers. “If you have the law on your side, pound the law. If you have the facts are on your side, pound the facts. If you have neither, pound the table.”
This lawyer’s dictum has been adopted by the active fund management lobby. With neither the Maths nor the results justifying active management, they pound the perils of passive. After denying efficient markets, the same Sanlam article argues, without a hint of irony or shame, that passive investing would make markets inefficient.
In their post-active world, capital will become misallocated, IPOs mispriced and small companies marginalised; liquidity will fall and volatility will rise. Lower economic growth and investor returns must follow. Will this cause capital to flee, the rand to collapse and food inflation to spiral? The author stops short of predicting that indexing will ultimately sweep Julius Malema into power, but it seems inevitable.
If passive management delivers similar, if not superior, returns to active management, it makes sense to follow this route, simply to avoid the risk of selecting an underperforming fund. Is it fair that passive investors hitch a free ride? Of course not, but then little is fair in the investment world the entire model is redistributive in nature, with an informed minority exploiting the disengaged majority. Letting the “other 99%” piggyback on the fear and greed of the 1% helps even the score.
Steven Nathan is CEO of 10X Investments.