Felix Salmon points us to a column by Mark Hulbert in today's New York Times. Hulbert reports on Kenneth French's effort to quantify the "cost" of active investing, and reports a headline figure of $100B. Felix pulls an excerpt from Warren Buffet's recent 2007 shareholder letter that serves a great way to frame the issue:
Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.
Buffet, as always, writes charmingly, and the logic here is unassailable. But there's a subtle point lost in this analysis. Sure, active investors as a class must earn less than passive investors as a class, if passive investors make the same investments in aggregate and pay lower fees. But it does not the follow that active investors, as a class, would have done better had they been passive investors. Why not? Because investors as a whole, including passive investors, would have earned poorer returns without smart active investors setting market prices. If active investors, as a class, accepted the logic that investment expenditures are just costs, all would become passive investors, and the composition of the aggregate portfolio would reflect nothing but noise. My conjecture is that this would impact long-term returns, adversely.
So active investors, as a class, do better than they otherwise would have by bearing the high cost of active investment, even though in doing so they must endure the indignity of being outperformed on average by those who free-ride off their work! It is perverse, under these circumstances, to accuse active investors of squandering $100B, and recommend that we all move to index funds. On the contrary, it is passive investors who ought be discouraged. Passive investors pay none of the costs of generating good investment decisions, but enjoy the benefits by free-riding on the work of others. Their copycatting reduces compensation to those who have earned returns by performing or underwriting informational work. Passive investing also introduces feedback effects and noise into asset prices, rendering the work of active investors more costly and less effective. (See, e.g. information cascades — ht Mark Thoma — and this interesting model of bubbles and crashes — ht jck of Alea — for ways that copying others' investment decisions as reflected in price moves can lead to instability and error in markets.)
The world of money management is full of shysters and charlatans who'll take "active investment" fees and do nothing useful with them, sure. But part of that headline $100B "cost" funds real information work, without which markets would devolve entirely to lotteries. Advising people to buy index funds rather than select investments is akin to advising people not to vote, since the cost of voting far exceeds any individual benefit. Those who don't vote get the same government everyone else does, but at lower cost! A citizenry that takes this reasoning to its logical extreme will get the government it deserves. An investor class that flocks to index funds may soon have the stock market it deserves.
Note: I haven't seen French's working paper, which might well have some discussion of these issues.
- 9-Mar-2008, 9:28 p.m. EST: Removed a superfluous "but".
- 9-Mar-2008, 10:10 p.m. EST: Changed a "his" to a "this".
|Steve Randy Waldman — Sunday March 9, 2008 at 6:28pm||permalink|