You can make more money being passively active than actively passive. – Robert G. Kirby

During recent years, there has been a gradual but steady increase in the use of index funds by institutional investors. This disturbs me, because I believe that superior investment research and management can produce consistently above-average results. Even beyond that point, however, I am also bothered by the wide, unquestioning acceptance of a form of indexing that appears to be seriously flawed. Nevertheless, despite these complaints, 1 do not disagree out of hand with those who adopt indexed investment programs.

We all know that, in the aggregate, professional money managers do not produce a return superior to that of a broadly based, unmanaged portfolio. We ignore the data that show that a few money managers have done consistently better, and a few others have done consistently worse. This means that we should not be surprised when an investor who has been a client of a poor money manager decides that he would be better off with an index fund. To beat the market is not easy. In addition to a good investment manager, the investor needs perspective, patience, and courage – qualities that do not abound in today’s intensely competitive world. For many investors, institutional and individual, an index fund may well be the best kind of common stock investment program.

Active Management
By cs:Wikipedista:Frettie (Own work (my own photo)) [GFDL or CC BY-SA 3.0], via Wikimedia Commons
Active Management

Why Index? And Why Not?

Perhaps I have a suspicious and cynical mind. Each surge in the popularity of index funds seems to follow a period during which the S&P 500 has been an excellent performer. Most index funds are not set up to avoid inferior performance; their purpose is to secure superior performance – just as when an investor hires a new investment manager with a great recent record. These are the wrong reasons.

Other investors adopt index funds for the right reasons. They believe that (1) the market is efficient in pricing assets so that it is virtually impossible to achieve consistently superior returns, and (2) the underperformance of professional money managers is the result of futile transaction costs. I disagree with these assumptions, but they support a position that is logical and makes sense. The question that completely perplexes me is why, with this sensible and logical approach to equity investing, these people then choose to replicate the Standard & Poor’s 500, which (1) is in reality actively managed, and (2) does not represent the market?

When Is Passive Active?

In case you’re shocked, let’s examine these two statements. First, on the point of active management, maybe you can accuse me of splitting hairs, because turnover in the S&P 500 is small in comparison to that of most ”active” money managers. Even modest activity, however, if it occurs year after year, produces a substantial cumulative change in the portfolio. In the past 10 years, Standard & Poor’s has made several hundred changes, both eliminations and additions, in their portfolio, and these changes have created transaction costs for holders of S&P 500 index funds. Further, the changes are not the result of a formula that produces a consistent, predictable kind of alteration: They represent individual judgments of the Standard & Poor’s staff, based on a combination of research and intuition, just as old-fashioned, active portfolio managers do it. Yet many people who are well aware that the S&P 500 is a faulty index are unwilling to go to the trouble to re-educate the investors whom they represent. But assume you are a brave and responsible fiduciary. What should you do?

In my opinion, you have two alternatives. Which you choose depends on your reasons for pursuing an index fund to begin with. Do you believe that the market is efficient and you want to adopt a program that replicates the market, because that’s the best you can do? Or, do you believe that traditional, active portfolio management incurs such high transaction costs that even the best money managers are unlikely to produce superior investment returns consistently? These are different reasons.

If you believe that a market return is the best an investor can hope for, you should pursue an investment program that will replicate the market, which is best represented by the Wilshire 5000 Stock Index. Clearly, it is impractical to use the actual Wilshire 5000. Such a program would drive both the computer and the trading department bonkers. The last 1000, or so, stocks in the index barely qualify as publicly owned and have about the same marketability as a 1961 Edsel. On the other hand, a tailor-made “Wilshire 1000” would represent 87% of the Wilshire 5000 and should be an acceptable proxy for ”everything out there,” providing true market results.

Via Sure Dividend, read the full article here.