In an op-ed in the Financial Times, Lex columnist John Guthrie writes that passive investing is built on a lie, namely passive guru Jack Bogle’s pitch: “Don’t look for a needle in a haystack. Just buy the haystack.”
According to Guthrie, the idea behind Bogle’s bon mot is that by going passive, investors can avoid the human error implicit in active investing: the chance that the active manager will buy a bunch of hay while looking for the elusive needle – and will miss the needle too.
Guthrie argues that this is a lie because the “haystack” in this metaphor – that is, the constituents of a particular index or the relative valuations in the stock market as a whole – is built by active managers in the first place. Active managers pick and choose stocks (in theory, at least) and by doing so, assign them relative values. Passive managers then sweep in and free-ride off active managers hard work by buying, say, the constituents of the S&P 500, which active managers picked.
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Now, Guthrie goes on to discuss various important issues arising from the spectacular growth of passive investing, such as the outsize influence now wielded by the world’s passive investing giants – Vanguard and Blackrock – and the potentially price-distorting impact of passive investing behaviour.
I haven’t much to say on this part of his argument – besides pointing out that passive investing only accounts for about 20% of assets under management, scheduled to rise to around 25% by 2028, and that price distortion is only expected to arise when passive accounts for over 50%, so we do have some time (like, around 20 years) to deal with what research suggests may be an overblown problem anyway.
Rather, I want to focus on the first accusation, that passive is built on a lie. This statement is not entirely fair. After all, to belabour the metaphor, passive funds do not promise to perform as well as those active funds that find the needle. Instead, they only promise to perform as well as the haystack (which, by definition, includes the needle, plus a lot of hay). In other words, passive funds aren’t promising outperformance. They are promising performance close to the performance of the index or market they are mimicking.
This is not the same as saying there will be no human error in the fund. After all, the entire history of equity markets is a study of human error, with endless boom and bust cycles. Passive funds are just promising to take people along on the ride for minimal fees.
When humans (specifically, the active managers who are “building the haystack”) mess things up, passive funds will lose value. When humans do a good job, passive funds will rise in line with earnings growth. When humans get stupidly exuberant, passive funds will shoot the lights out along with the market. Human error is implicit in all of this, and that’s all passive funds promise.
Investors are then free to choose how to expose themselves to human error. They can expose themselves to the particular errors of a single human or team by buying an active fund, or they can expose themselves to the collective, aggregate errors of a bunch of humans, by buying active funds. Or they can do both, by allocating to both types of funds. That is what Bogle is offering – you can buy the haystack, you can buy whatever a person looking for the needle finds, or you can buy both.
In addition, as important as it is to be clear what passive funds offer, it’s also important to be honest about active funds. In theory, active funds are offering investors a top-notch, needle-finding operation that will dig relentlessly through the hay until the needle is found. That’s the basis for the extortionate fees that active funds charge.
In reality, however, many active funds actually just buy the haystack (and charge a fortune for doing so). Study after study shows that many active funds are simply closet index huggers – they basically replicate the contents of whatever index they have chosen to use as a benchmark, with a few superficial and insignificant tweaks (insignificant in the statistical sense, and the sense that they do not materially affect performance). Despite the passive revolution, many funds continue to follow closet strategies – indeed, European regulators are cracking down on “closet trackers” in a bid to improve market quality.
What’s more, active funds are designed so that they get paid whether they find the needle or not. Fees are based on AUM, not performance – although there’s often a performance fee tacked on for good measure. This is a bit like paying for a litre of milk at the supermarket whether or not they have any in stock. Passive funds promise to deliver close-to-market performance and charge minimal fees for doing so. Active funds promise to beat the market and charge substantial fees whether they do or not.
Active fund managers’ strategy for dealing with the rise of passive has been to try to rubbish passive as a strategy and raise hyped-up concerns about the fate of capital markets. Instead, they should take an honest look at their funds, what they promise, what they deliver, and what they charge, and build products that actually compete with passive.
For example, imagine an active fund that promises to charge fees when it outperforms and to pay investors fees when it underperforms. Suddenly, this looks like a real alternative – a needle-finding operation that puts its own skin in the game and gives investors something when the needle isn’t found.
If active managers want to stop the rise of passive, they should stop trying to sell us all an inferior product and insisting we should be grateful for the chance to buy it.
