Weekly Recap 7/20/2018: The Passive vs Active Debate

Weekly Recap

S&P 500                +0.05%

10 Year Treasury   -0.38%

Gold                      -0.88%

Volatility              +5.5%

Weekly Update:  The Passive vs Active Debate

Over the last 10 years there has been a lot of discussion regarding the benefits of active stock managers as measured against the lower cost passive index following mutual funds or ETFs (Exchange Traded Funds).  To clarify, the performance of active stock managers is usually measured by the performance of mutual funds which do not index their stock selection, but rather select stocks to invest in based upon fundamental analysis of a company’s market position, industry outlook, and balance sheet. 

In choosing active stock management, the investor would be hoping to either reduce downside stock market exposure or seek outperformance.  To be blunt, the manager better beat the market when it’s going up or when it’s going down.  Inability to do one of either is a clear sign of failure on the manager’s part.  This isn’t something that should be analyzed over the course of one month, or a few quarters, but rather a full business cycle. 

In this regard, many active managers have failed on both accounts.  They neither buffered the against the downside in ’08-’09, nor have they outperformed since 2012, when the market really began its bull charge.  However, maybe that’s not an indictment on active management as a field, but rather an indictment on a particular style of management.  As I mentioned earlier, most active managers select stocks based upon fundamental analysis, a “bottom up” approach.  It is an approach that has been around since the beginning of the stock market, and its success rate has been in question for some time.  One thing is for sure, fundamental analysis is good at creating a story to buy.  In my letter from 6/29, I wrote about the challenges of narrative reasoning.  Fundamental analysis falls in this category in my opinion.  It presents a nice story to buy, but ultimately is prone to a myriad of behavioral financial flaws. 

Humans are prone to a myriad of cognitive errors and emotional biases. For example, selection and confirmation biases obstruct a manager’s ability to properly decipher data and information critical to analysis.  Furthermore, conservatism¹ and sunk cost² biases potentially cause managers to hold onto stocks too long because they continue to believe the original story.  Behavioral flaws are not exclusive to everyday investors, even the pros are prone to these too.  Therefore, it would seem that the debate in favor of passive indexing would win the day over active, fundamental stock picking.  The results are in the favor of the passive camp, as well as the psychological factors that are stacked against active management.

However, where I diverge from the passive camp in this debate is on the grounds that a victory for passive management is a victory for efficient market theory.  Efficient market theory essentially believes that the price of an asset is always right.  Market price movement today or yesterday provides no hint as to what the market will do tomorrow.  That is the theory behind the efficient market hypothesis.  In my opinion this seems ridiculous.  The story that the tape tells can give valuable information about the near-term future prospects of an asset.  We just have to know where and how to look.  Quantitative finance practitioners use statistics and probability theory to analyze market data and design algorithms to exploit patterns.  These algorithms then become “trading programs.”  Where this method succeeds is that it is a sort of blended form of active and passive.  The analysis is active and adaptive, but the process is passive.  The algorithm, designed by humans, takes what is great about the human mind, the ability to invent and adapt, and discards the negative side, which is the ability of our emotions and senses to distort and interfere in the area of complex analysis.  Our emotions and senses are what make us alive.  I am a true romantic, but I know it can be a negative when it comes to analyzing complex functions.

Next week I will discuss how quantitative analysis can help us design a momentum based system which can make sense of some of the data. 

Thanks for reading,

Zach and Dave

Calibrate Wealth
515-371-5316  

https://www.calibratewm.com/blog-01

1. Conservatism – A cognitive error where an individual place more emphasis on the information they used to form their original forecast than on new information.  This is a form on inertia.  Humans simply lack the capacity to analyze new information every day to properly readjust their forecast.
2. Sunk Cost Fallacy – An emotional bias where an individual is anchored to a decision or action based on prior investment or effort.  For example, going to a concert that you bought a non-refundable tickets to that you no longer want to attend.