“Advice that works on average” is also known as “good advice.” – Bryan Caplan
In a post up at EconLog Caplan discusses why it is so much socially acceptable to tell people to “try harder” when in fact the best advice would be to “do something easier.” Caplan applies this logic to opening a restaurant, choosing an occupation or going to college. He writes:
Say it with me: Risk of failure is a reason not to try. Not a decisive reason, but a reason nonetheless – and the higher the risk of failure, the stronger the reason. True, if you have no alternatives, you may as well try your best and hope for the best. But would-be restaurant owners and would-be students always have alternatives. And as long as you have alternatives, willingness to Do Something Easier in the face of crummy odds is not cowardice. It is good economics – and common sense.
This same logic could easily be applied to investing as well. In this framework active management represents “trying harder” and passive management represents “doing something easier.” The financial services industry is built on the idea that your money needs to work harder to earn better returns.
“Working harder” is usually accompanied with additional fees to pay for this additional effort. Barry Ritholtz at Bloomberg View talks about why it is that despite relatively tepid performance over any reasonable time span hedge funds continue to attract (and retain) assets under management. That is why Ritholtz argues that unless you can get access to a truly top-tier hedge fund you are better off focusing on low-cost beta.
We all know the old adage, if you want a friend, get a dog. Perhaps an amended version should be, if you want alpha, get into a top-tier hedge fund; if you can’t, then stick to beta.
It seems like Americans are taking this advice. From 2003 to 2013 the percentage of mutual fund and ETF assets that are passively managed has increased from 12% to 27%. By all accounts this percentage is set to continue to go higher. Part of the reason may be that the growing wave of automated investment managers, or robo-advisors, almost exclusively use passively managed ETFs to help build client portfolios. That is why Adam Zoll at Morningstar writes:
But in a larger sense, the growing use of passive investment vehicles reflects the times in which we live. With algorithms helping determine which online ads we’re exposed to each day and new metrics being invented all the time to aid in arenas as diverse as business, politics, and sports, perhaps it should come as no surprise that more people are willing to rely on an inexpensive, systematic, formula-based approach to investing rather than on the judgment and decision-making ability of a living, breathing fund manager.
One of the big problems with active management today is they are simply charging too much for their services. That gap will only continue to grow as passive strategies continue to see their costs pushed towards 0%. Cullen Roche at Pragmatic Capitalism argues that active managers can add value especially in a bear market but the fees charged are still too high. He writes:
And that’s the thing – as long as there are bear markets there will be active managers implementing strategies designed to reduce tail risk in portfolios. And they will be providing their clients with an extremely valuable service. In general, I think it’s probably safe to say that there’s an excess of more active managers at present and that many of these active managers are charging fees that they can’t justify. But that doesn’t mean they’ll become extinct.
Indexing is no panacea. As Phil Pearlman at Yahoo describes indexing as: “the worst form of retirement investing except for all the others.” As Pearlman notes if you take active management off the table there are still plenty of ways that investors can muck up their portfolios through all manner of bad behaviors. But in the active vs. passive debate for now it appears that investors are choosing to “do something easier” than “try that much harder.”