Taking Stock of Morningstar's Active/Passive Investing Week
Last week was Active/Passive Investing Week at Morningstar, during which they posted a number of articles and interviews that covered just about every angle of the active/passive debate.
For newcomers to this debate, there's a great deal of good material there to learn from. But as I reviewed it, I came away with two main reactions.
First, as I read the pro-active management arguments, what struck me most was just how vapid those arguments are. For instance, consider some of the pointers offered by Morningstar's Director of Personal Finance Christine Benz, who shared her tips on selecting active funds.
Benz on assessing fund managers: "Manager tenure is a good starting point. You might hear people say, look for manager tenure of five years, or something like that. I say the longer the better ... you want to have the most number of observable data points that you can possibly have."
Makes sense, right? The problem is that a manager's past record has nothing to do with how he or she will perform relative to the market in the future. Bill Miller is one of the industry's longest-tenured managers, and owner of one of the longest streaks of outperformance ever recorded. Unfortunately, over the past three-plus years, that record has been obliterated as his funds have dramatically underperformed their benchmarks.
Benz on other factors to consider: "You want to have a thorough understanding of the strategy. You want a strategy that makes sense to you, that intuitively appeals to you. For example, one strategy I find personally compelling is the contrarian strategy, where a manager is looking for high-quality companies but wants to buy them cheaply."
I love this one. Who isn't looking for a manager who can buy high-quality companies cheaply? On the other hand, are there managers out there who say their strategy is to buy horrible companies that are overvalued? Perhaps I've missed the study which shows the correlation between a well-articulated investment strategy and outperformance.
But the reality is that, if you're trying to defend an investment approach based on active management, arguments like the above are really all that you can rely on.
In making their case, indexing proponents can point to decades worth of real world experience that show the superiority of their approach, along with literally hundreds -- if not thousands -- of academic studies that demonstrate the futility of trying to pick a winning fund.
In contrast, the pro-active management quiver is essentially empty, their proponents armed largely with platitudes like those Benz articulated. Their argument -- at its core -- is basically "Yes the odds are long, but trust me, I can do it."
Which gets me to my second reaction to Morningstar's series. New York Times columnist Paul Krugman often takes the media to task for (in his opinion) their overarching efforts to make to present an objective view in political debates, writing that if members of one political party said the earth was flat, the headlines would read "Opinions Vary on Shape of the Earth."
That headline kept coming to mind as I read much of the Active/Passive Investing Week material.
Look, I get it. Morningstar is largely staffed by folks who are investment junkies, who love nothing more than sifting through reams of data in an effort to uncover a gold nugget. And to the extent that they figure they can devise a method to pick the next winner, I say best of luck.
But at the same time, they know far better than most of their readers just how long the odds of picking that winner are, and how the most elemental mathematics dictate that the most prudent approach for the average investor is to put the odds firmly in their favor by buying and holding a low cost, broadly diversified portfolio of index funds.
But instead of that, there was a false equivalence between the two choices, as if building a portfolio of actively managed funds was as logical and rational as building one from passively managed funds. But it's not. Now if you're fully aware of the long odds you face with actively managed funds, and still choose to play the game, good luck to you. The problem is that the vast majority of investors are oblivious to those odds, and when they read the experts at Morningstar saying, essentially, that the pros and cons of each approach are equivalent, they're being misled.
A far more honest approach -- and one that would have best-served their audience -- would be for Morningstar to say, essentially, that most of their readers would be best-served by opting out of the chase for outperformance and sticking with passive funds. Is such advice exciting, sexy, and sure to drive traffic? Decidedly, no. But on the other hand, it does have the benefit of being true.
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