At the end of a rare second consecutive losing month for stocks, it was interesting to read the comments of Goldman Sach's Tim O'Neill on the topic of active versus passive investing, although given that he is 'primarily in the business of active investing', his opinion on the subject is not the biggest of surprises:
Tim O'Neill, Goldman Sachs' partner and global co-head of the investment management division, has a warning: If passive investing gets too big, then the market won't work.
"So in terms of the size, a market needs both active and passive investing because if everybody's a passive investor, there's no one to buy from," O'Neill said on a new "Exchanges at Goldman Sachs" podcast with communications chief Jake Siewert. "And if passive becomes a certain oversized percentage of the market, the market doesn't function."
O'Neill is getting to the heart of the debate on active vs. passive investing. Passive investing has boomed in recent years, with index-tracking exchange-traded funds hoovering up trillions in assets under management.
The problem is that the market needs active management, otherwise there will be no one to buy from, and individual stocks will just move with the overall index.
As a result, O'Neill, who previously called passive investing "a potential bubble machine," said that both strategies are necessary.
Here's an excerpt:
Well, the promise of active investing is that they're going to deliver performance net of fees better than the benchmark, whatever the benchmark might be for the US, global, or Europe. It's been a difficult seven years for active investors because the markets have risen so consistently and persistently higher. So most active managers have net of fees underperformed the benchmark. So it led back to this debate about whether or not the fees that you pay for active managers are worth it. And there's been simultaneously a great shift towards passive investing because it's cheap, and you would get all of the market returns, net of five or 10 basis points.The problem for passive is that its size, at a certain point, may be too much for the market to handle. And it's also all on autopilot. So in terms of the size, a market needs both active and passive investing because if everybody's a passive investor, there's no one to buy from. So there's no one ... your beta is my alpha and vice versa. So you need a balance in the market. And if passive becomes a certain oversized percentage of the market, the market doesn't function.
The other problem with passive, of course, it's all on autopilot. And when you get to periods of misvaluation, over or undervaluation, you need active decision-makers. Because valuation always matters in markets, and investing.
Rather than choose one of these philosophies over the other, I take the unpopular stance of embracing them both, and there are very good reasons to do so. Let me explain how I came to this position. Take a look at the (above) graph, which shows schematically what percentage of active managers outperformed the passive S&P 500 index investor.
Clearly there is some type of vague cyclicality here. There seems to be a horizontal line at 45% around which the graph oscillates. At some points such as March 2005 to March 2006, and again in March 2009 to March 2010, a high percentage of managers outperform the S&P. On the other hand, these periods of strong out-performance are followed by sudden drops in performance. That is, the passive investor beat the active stock picker. I’m proposing the following behavioral reasons for the cyclicality:
Picture many highly skilled analysts all competing to obtain and synthesize relevant information on a stock before everyone else. So many are working so hard, that it is difficult to uncover valuable information before others. At the extreme point, where all information is known by all hard-working analysts, there is virtually no advantage to staying in the game if you’re hoping to gain an information edge. Ironically, staying–and expecting not to gain an information edge–would ensure that no one else gains the information either.
If all keep working as hard as possible and none drop out, active management has no edge. With no information edge, indexing begins to look like an appealing alternative and may very well be outperforming active management. But what if some participants become discouraged from the lack of return on their efforts, and they drop out of the active circle and choose to index? That creates the opportunity for the other active die-hards that haven’t given up.
I propose that this dynamic is behind the cyclical shifts of active versus passive performance:
When market participants become frustrated by the lack of out-performance of active management, some exit the active arena, choosing instead to index. That very exit from the active arena sets the stage for the remaining active managers to outperform. The siren song of active out-performance then lures those participants back in the game. But when everyone piles into active management, the ability to gain an information advantage diminishes, causing the cycle of switching back to passive again. And thus the cycle continues. In an odd way, one could argue that the oscillations between active and passive promotes a type of market stability.
Examine the graph again, this time keeping my theory in mind. I’m sure you will see the pattern makes more sense. When considering the choice of active versus passive, a more reasonable answer is to open your mind to both alternatives, not just one.