jacob

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Notes to my future self

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Passive investing beats active

A professor at NYU has provided empirical evidence that passive investing beats active. He also explains why this is. Any avid reader of financial literature already have heard these arguments, however, professor Damodaran's video presentation and blog post is an easy read for anyone that does not have a thorough financial background. Damodaran breaks his argument into four sections.

1. Active managers cannot collectively beat the market

This is just pure math, as proved by Sharpe in 1991. Some active managers must have returns higher the market, and some must have returns lower than the market. As a collective, they will have a return equal to the market. After including fees, however, the sum of all active investors will be beaten by the market due to trading costs.

2. Sub-groups of active investors do not beat their index

Active managers investing in a certain style (e.g. large cap growth stocks or stocks with low PE or high dividend yield) do not beat their sub-index. This is logical since almost any style can be replicated with an index - at a lower cost than the active manager.

The empirical evidence on this is large enough that it is now considered a well known fact. As an example, here is an excerpt from the abstract of Jensen's influential 1967 paper:

The evidence on mutual fund performance indicates not only that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-marketand-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance.

3. Top performers do not stay top performers

The last argument for active investing is that whilst the two previous arguments are true, there exists people who can make the right judgement call and beat the market consistently. Data suggests the opposite. By ranking the portfolio managers by quarter in one period, and then studying how they performed in the following periods (a so called transition matrix) we can draw the conclusion that the top performers do not stay top performers.

Moreover, a simple graphic from Morningstar suggests the superstar fund managers quickly came down to earth during the years after being named as a top performer. This is logical, since risk taking can give extreme returns - sometimes extremely positive and sometimes extremely negative.

Damodaran's arguments are inline with those made by Fama in his 1961 paper "Efficient capital markets" where Fama writes

... for individual funds, returns with performance above the norm in one subperiod do not seem to be associated with performance above the norm in other subperiods.

4. What about outliers like Warren Buffet?

Pulling out this outlier argument is a sign of weakness and desperation - the activist already lost the debate. It is impossible to tease out skill from luck in such rare cases like these.
It must be the case that some fund managers outperform the market - a few outliers a posterio are to be expected. This does not imply there are trading strategies that a prioir are profitable. Fama makes a point about this in his paper as well, where he writes "the number of funds with large positive deviations of returns from the market line of Figure 2 is less than the number that would be expected by chance", which is an academic way of saying they were lucky.

Conclusion

Damodaran sums up his article with the following sentence:

The performance of active money managers provides the best evidence yet that indexing may be the best strategy for many investors.

He also makes a closing remark on the industry as a whole:

... active investing, as structured today, is an awful business, with little to show for all the resources that are poured into it. In fact, given how much value is destroyed in this business, the surprise is not that passive investing has encroached on its territory but that active investing stays standing as a viable business.


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