I recently came across this excellent interview given by distressed credit investor Howard Marks (Trades, Portfolio) at the Wharton School of Business, in which he talks about the contradictions inherent in passive investing. It’s a really interesting point of view, and one that I hadn’t considered in the past, so I hope you’ll enjoy it too.
Most active managers underperform
Marks began by admitting that most active investors underperform the index. He said:
“Most active managers have not done as well as the index, and it stands to reason because on average, everyone is going to do average - before fees - and below average after fees. So it’s only the exceptional people who are going to beat the index after fees. Not everybody - not the average person - but the exceptional person. Further, most people aren’t in control of their emotions, most people, by definition, are not contrarian.”
The big shift toward passive investing was fuelled by the growing realization that most active investors underperformed the market, with outliers like Warren Buffett (Trades, Portfolio) being the exception that proves the rule.
The irony of passive investing
This sets up the central point that Marks is making - even though passive investors think that active managers are incapable of outperforming the market, they rely upon the work of active investors to determine the weighings that are assigned to stocks within the indexes they follow. As Marks notedL
“Why do the stocks in the index have the weighting in the index that they have? Where did these weighting come from? They don’t come from above. They don’t come from the operation of nature, or physics. 'This stock has a weighting of $80 billion, that stock has a value of $180 billion.' Why? Partially because what the companies accomplish, and partially because of what the investors say they’re worth. So the market pricings, or the weightings, are assigned by whom? Active investors. And yet there’s a trend towards passive investment on the premise that active investors don’t really know what they’re talking about. And yet, the MO of the passive investor is to emulate the decisions of the active investors who they think are idiots.”
It used to be that a small number of passive investors could freeload off the hard work being done by active managers. Instead of doing the painstaking work of independently valuing each company in the S&P 500, the passive investor could just copy the work of his active rival. But when the passive side of the market gets as big as it has today, who is the one deciding the valuations of the companies? Do we run the risk of the process becoming a self-reinforcing cycle, with companies being overvalued just by virtue of their inclusion in an index? If this happens, what implications will this have for the practice of valuation? I’m not sure what the answers to these questions are, but I am sure that we are now in uncharted territory. Let’s see where the journey takes us.
Read more here:
- ”‹Warren Buffett on If You Need to Go to Business School to Be a Good Investor
- Jeffrey Gundlach: Nominal GDP Would Be Negative If the US Did Not Take on Debt
- Seth Klarman: What Happens When Bad Money Drives Out Good Money
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