Active vs. Passive Management
Scores of papers and blogs have been written about the merits of passive vs. active management. I’ve contributed my share and here is one of my earlier posts. Readers will find more articles by moving over to the right sidebar and looking up Passive vs. Active blogs. There are over 25 posts on this subject.
When you read about active management outperforming the market, check on a few variables or assumptions. 1) What benchmark is used? This morning I was reading a Seeking Alpha on this subject and the actively managed fund was using stocks outside large-cap companies, but the benchmark was the S&P 500. That is not a fair comparison. So look out for the comparison benchmark. 2) What time period is used in the measurement? Launch date of the actively or passively managed portfolio makes a big difference. 3) Is the comparison net of fees? Actively managed mutual fund fees drag down performance by at least 100 basis points.
To be sure, there are actively managed portfolios that outperform an appropriate benchmark. The law of averages demands this be the case. However, if one can hold down expenses, there is a high probability the small index investor will outperform the professional by the difference related to the cost of management. This is William Sharpe’s argument in his article, The Arithmetic of Active Management.
Here is my challenge to active investors and/or researchers who happen to be looking into the question of active or passive management. 1) Find over 100 small investors who actively manage their own portfolios. The larger the number the better. 2) Collect all broker statements for portfolios that have been operational for three years or longer. Some of the portfolios should have 15 to 20 years of data. 3) We want portfolios of different size and different launch dates. 4) Develop a customized benchmark for each portfolio much like the ITA Index used with the ITA Wealth Management portfolios.
Supplied with the appropriate data, enter all the information into a site such as bivio or a software program such as the TLH Spreadsheet. Then determine what percentage of these investors outperformed both the VTSMX and a customized benchmarks. Where is the evidence that active managers outperform passive or index investors?
If you are an active manager as defined by Harold Evensky, and think you are outperforming an appropriate benchmark, prove it to yourself by setting up the TLH Spreadsheet and track your performance. Since every portfolio is different in size, makeup, or launch date, your portfolio is the one to test, not some virtual portfolio. Test the portfolio real time and going forward. Forget the back testing results as I never met a massaged back test I did not like.
Photograph: Road that leads into Lhasa, Tibet