An Ode to Passive Management

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In the revised edition of The Incredible Shrinking Alpha, Larry Swedroe and Andrew Berkin make the case that investors are better off choosing passive investments because markets have become more efficient as managers became more skilled.

Their case is predicated on four dynamics at work in markets at all times. Empirically oriented practitioners and academics in finance are constantly at work creating and revising models that forecast expected returns. These models are informed by the same sources of information used by active managers to make active bets on securities. In this way, academic finance commoditizes the proprietary edges that active managers use to produce excess returns, effectively transmuting alpha into beta.

Active managers are always trying to hire the most talented analysts and portfolio managers, who are in turn leveraging the most advanced technology and data sources to gain an edge over the competition. Excess return is always a zero-sum-game because every dollar harvested by one investor above the return of the market must be “donated” by another investor. As managers become more skilled and equip themselves with better tools, they arbitrage away the edges that produced alpha in the first place. Markets become more efficient, which diminishes opportunities to produce excess returns.

It follows that if active managers are producing less reliable excess returns, investors will find active management less attractive at the margin. Unsurprisingly then, investors have been abandoning actively managed funds in favor of index products for most of the last decade. This further complicates the job of active managers since the investors most likely to abandon active management are those who have the least skill to choose active investments. Definitionally, active managers profit from the mistakes of unskilled investors. If there are fewer unskilled investors in the market, the pot of excess returns grows smaller.

Paradoxically, while individual investors have been selling actively managed funds to buy index products for many years, institutional investors, like pensions, insurance companies, and endowments, have never been so enamored with active investments. The authors cite a study showing that institutional allocations to hedge funds grew from zero to 6%, and allocations to private equity increased from 3% to 11%, over the 20-year period ending in 2016. This despite the fact that returns to alternative investments in excess of simple replacements (like allocations to small-value stocks and REITs) declined precipitously over the same period. This behavior may seem confusing until one recognizes that institutions typically operate under a strict required-return objective. With bond yields on a steady decline and high stock valuations implying low returns, it is less surprising that many institutions might “take a shot” at low-probability active bets.

These bets have not paid off, with alternative sleeves underperforming simple index alternatives.