Passive Investing – Visiting And Learning From The Past

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I recently had the pleasure of spending a week in the Czech Republic.  We enjoyed the stunning city of Prague, but I also had a chance to explore the city of Brno while my husband hit the conference circuit.

Passive Investing

Brno is not on the typical American bucket list of sights to see, but sometimes it is the unusual surprises that are the best.  My unusual surprise in Brno was the monastery where Gregor Mendel performed his famous experiments with pea plants, cracking open the first secrets of genetics and enabling all the later discoveries of biology, medicine, chemistry, and anthropology that followed from it.  Before Mendel formulated the theory of genes to transmit biological information through generations, Darwin’s entire evolutionary theory was nothing but an explanatory fable.  Only with Mendel’s genes to provide a viable mechanism for the process of evolution, did Darwin’s proposal then begin to be considered a reasonable possibility by the scientific community.

Mendel was not a giant among intellectuals or scientists in the class of Newton, Einstein, or Feynman, but his discoveries have had just as far-reaching effects.  He was a simple monk that couldn’t even pass the exams to teach at higher than a primary school level despite multiple attempts.  What he had, however, was a mind unadulterated by the dogma of the day regarding reproductive biology and trait formation.  He also possessed patience, a meticulous attention to detail and documentation, and the work ethic to generate the data necessary to formulate his theories.  Investors would be well served by taking stock of Mendel’s habits. His story is well told in The Gene by Siddhartha Mukherjee.

Figures like Mendel are useful to study because they can teach someone who doesn’t have the mind of a Newton or Einstein how to better observe, absorb, and process information.  Mendel didn’t fall prey to confirmational biases and force the data to fit his models.  He observed, collected, and then formulated. By doing so he was able to leap to a completely novel concept – the heritable gene transmitted through sexual reproduction.  And he did this fully 100 years before the actual structure of DNA was solved, before we even knew what an atom was.  Now that is revolutionary thinking!

Bonus for Brno visitors: copies of his lab notebooks are on display for viewing in the museum!

The past works of science have been performed by all sorts, both humble monks, and more flashy types as well.  An interesting example of the latter can be seen in another scientist of the era – the brilliant, but smug Lord Kelvin who also weighed in on Darwin’s new ideas.  He was a maestro of thermodynamics and using these skills, he attempted a calculation of the age of the sun and reached a figure of ~500 million years.   This length of time would not have been nearly long enough to support the slow process of evolution.  Thus Lord Kelvin promptly denounced evolution as preposterous based on his calculations.  Kelvin’s figure was an accurate number given the inputs of classical thermodynamics.  But he failed to consider that there may be other potential, undiscovered mechanisms of combustion such as nuclear fusion, which in fact is what the sun does.  To be fair, Kelvin did add the following disclaimer to his estimate of the sun’s age – “I do not say there may not be laws which we have not discovered.” This statement contains a passive/aggressive amount of negatives but is more generous than some of his other proclamations.  His most infamous by far – Kelvin addressed an assemblage of physicists at the British Association for the advancement of Science in 1900 by stating, “There is nothing new to be discovered in physics now. All that remains is more and more precise measurement.”  Don’t tell Einstein about this!

The rear-view of these past scientists can be used to help us avoid such mistakes in the present.  What we need to be vigilant against are informationally self-satisfied attitudes reminiscent of those of Lord Kelvin.  In the world of investing, one of the current prevailing thoughts that reminds us of this “nothing new under the sun” point-of-view is with respect to active portfolio management.  We have written in the past about the potential pitfalls of passive investing, but today we would like to draw your attention between the similarities of the language of the indexers to that of Lord Kelvin.  Those proclaiming the death of active investing often cite the near impossibility of finding new, undiscovered pockets of higher-than-average returns in today’s world of open information and high-speed communication.  (We will have more to say about this “brave, new world” in a future post).  All that remains, they claim, are better and better algorithms to re-balance your indexed portfolio and keep it apace with the market averages.

It is not difficult to see the similarities between these proclamations and those of Lord Kelvin nearly 100 years ago.  It ironic that one of the most vocal proponents of passive indexing, Charles Ellis, is a past chair of the board of the Chartered Financial Analyst Society.  The CFA Society, of which we are active members, is a wonderful organization providing some of the most comprehensive education available for the practice of investment management.  Mr. Ellis has only the best interests of investors in mind in providing his guidance, and his messages of paying attention to fees are important and useful ones.

But a position that active management, on average, cannot outperform the market averages is a recursive, self-referential one with no added informational value.  Moreover, outperformance of averages via the purportedly extinct astute and singular market insight is only one way in which an active manager can provide value.  A less flashy method, more in keeping with Mendel’s ways, is through a disciplined, meticulous process that actively seeks to avoid the psychological fears and biases that often keep the individual indexing investor from achieving those much ballyhooed “market returns.”  The active manager can talk the overly anxious or euphoric investor down off the investment ledges and ladders that emotion can lead one to climb which ultimately result in broken portfolios.  This more mundane methodology, grounded in trust, is what Broyhill seeks to employ.

Time is the ultimate arbitrator of all arguments and this one between active and passive investing will be no exception.  Before we sign off, however, we will leave you with just one more thought of relevance from the past – perhaps both views are correct.

“Whether you think you can, or think you can’t . . . you’re right.” – Henry Ford

Article by Andrea Sefler, Broyhill Asset Management

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