Wall Street Journal columnist Jason Zweig recently issued “a split decision in the passive vs. active brawl” for the “Great Fund Debate” between Vanguard founder John Bogle and newsletter writer James Grant. That’s a curious verdict because Bogle has the numbers in his corner while Grant relies primarily on rhetoric and the hope that the disappointing history for active management could be different in the years ahead.
“When you buy ‘the market,’ you are buying David [Blitzer]’s market and Janet Yellen’s,” Grant reportedly said last month at a conference where he debated Bogle. “Are you quite sure you want it all?” That’s a good line in that it suggests that index investors are slaves to the whims of the Fed’s monetary policy and Blitzer’s index committee that selects stocks for the S&P 500. It’s a clever way of implying that Yellen and Blitzer are a cabal that’s managing your money. What to do? Dive head first into security selection and take charge of your destiny, or so Grant advises.
“I think there are many ways to make money or lose money,” Grant explained, “and Jack says there is but one.” The newsletter writer said the Vanguard’s founder
reminds me of a kind of Debbie Downer Little League coach who lines the kids up and says, “I don’t mean to sound discouraging, but in the big leagues it comes in at 93 mph… and beyond that, your career’s likely to be short, and most guys wash out in the minors. So I’d play softball.”
But investing isn’t baseball, as the large number of investor’s who’ve been beaned at home plate can attest. There’s a deep pool of academic and empirical research that tells us, as Charlie Ellis famously counseled, that we shouldn’t try too hard (if at all) to win at a loser’s game.
This isn’t really much a debate because the numbers overwhelmingly stack up in Bogle’s favor whereas the most that Grant can muster is a pep talk about how there’s a possibility (albeit a slim one) that you can beat the odds and outperform indexing over the long haul. But that’s a tough challenge to overcome. Indexing’s winning mix of low fees and a high reliability of achieving middling-to-above middling results within its target market, combined with active management’s drag of higher expenses and human error, tend to deliver predictable outcomes.
Hoping for an alternative reality isn’t recommended, for one simple but powerful reason: The “Arithmetic of Active Management.” A number of years ago Professor Bill Sharpe summarized what has become the iron rule for portfolio analysis and investors ignore this quantitative reality at considerable peril:
Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.
Market-beating returns–alpha–is a zero sum game. And once you factor in the higher costs and unreliability of active management bets, indexing’s edge becomes a force to be reckoned with through time. Any cursory review of the numbers speak volumes on this point.
Even the all-time champ of active investing seems to acknowledge this fact and dispenses wealth management advice accordingly when it comes to strategizing for the years ahead. Writing in his 2013 letter to shareholders, the Oracle of Omaha dispensed relatively pragmatic and arguably un-Oracular instructions for the management of his assets after he joins history’s team of financial genuises in the sky:
My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.
Grant’s rejoinder is that indexing is fine for the average know-nothing investor, but that “ought not to be true” for “the accomplished professional investor.” Sounds reasonable, but the facts make mincemeat of this seemingly logical observation. Indeed, the fact that indexing generally does so well is testament to the reality that most professionals fall victim to the Arithmetic of Active Management.
Grant would also like you to believe that indexing is a dull affair that requires holding one or two broad-based funds of stocks and bonds. Reality, of course, is far more nuanced, or at least it could be. The rainbow of indexing possibilities in ETFs and mutual funds facilitates a degree of customization that can rival strategies built on individual security selection. That’s not necessarily a reason to pursue a deeply granular asset allocation design, although it’s a reminder that one need not exit the house of indexing to pursue a more ambitious portfolio strategy beyond a plain-vanilla S&P 500/US bond market recipe.
It should be noted, of course, that Bogle’s tolerance doesn’t extend much beyond broad-brush indexing concepts. Similarly, the idea of trading ETFs for short-term horizons is unreservedly rejected by the man who launched the business of indexing for the masses some four decades ago.
The capacity for building a globally diversified portfolio with a granular and relatively exotic set of betas that are actively traded is largely anathema to Bogle’s investing sensibilities. On the other hand, the relative ease and low expense of running the equivalent of a global macro strategy via ETFs may appeal to Grant, at least in theory. Perhaps there’s a tiny bit of common ground for the next round of the Great Fund Debate.