Active vs. Passive Investing: There's No Real Choice

Happy and Prosperous Lunar New Year. I met a lot of interesting people and heard about many new technologies and innovative products in New York last week. Navigating the future financial landscape requires making use of optimal ways to access information, deploy investment capital and manage risk. We can't rely on beta so it is alpha we need to identify for absolute returns. There is no asset allocation; it is how different strategies are applied to those assets that matters. There is also no passive investing; only active investing exists in the real world. And the notion of long term gets shorter term every year.

Why does the 12 year cycle in Chinese astrology begin with the rat? Because the alpha rat was smart, small and nimble enough to beat the lumbering beta ox, dragon, horse and others to win the race. A hedge fund manager is an investment rat; able to survive conditions that destroy others, exploit crevices of opportunity amid adversity and outperform the slower and bigger financial fauna. They are often hated by others for their very existence or wrongly blamed for propagating any disease that hits the markets. Much of the investment jungle is inhabited with brainless brontosauruses and preening peacocks strutting around unwilling or unable to do the dirty, hard work of uncovering alpha. If you were an animal, what animal would you be? As far as finding good investments is concerned, look for an alpha rat. Rats figure it out no matter what happens.

Warren Buffett is a hedge fund manager and has spotted an opportunity to try to make some money by reinsuring the municipal bonds insured by MBIA (MBI) and Ambac (ABK). It is unlikely his offer will be taken up and it does not change the dire outlook for those firms' holdings of CDO toxic waste. The stock market is STILL not recognizing the growing problems in the CLO, CDS and LBO debt markets. Buffett's offer may sound like a positive but it is a negative for the monoline stocks. It likely signals his interest in stepping in should those firms go under due to their more exotic liabilities. Out of crisis there is always opportunity and he has been successfully generating alpha out of special and distressed situations for a long time.

Probably the most sensible large private equity LBO last year was the Harrahs deal. Going down the left side of the Vegas strip after you pass the Venetian you encounter several blocks of 60s and 70s casinos in prime locations including Harrahs itself or owned by Harrahs, all of which would best be demolished and replaced with a modern mega resort. Harrahs needed to be private for a few years as it forgoes statistical arbitrage gaming revenue and builds for the future. So the fact that a strong LBO with a solid business rationale could not raise sufficient debt funding shows just how bad things are. This is not the end of the credit crisis, we are not even at the end of the beginning of the credit crisis. Those hedge funds that bought some distressed portfolios late last year might yet find out that vulture investing works best when the carcass really is dead.

Microsoft (MSFT) wants to buy Yahoo (YHOO). Both ARE great companies but WERE good stocks once. I doubt Google (GOOG) lost any sleep other than brainstorming some deal delaying tactics; its search technology is vastly superior and its "new" competition will take years to integrate their cultures if they ever do. Industry and product lifecycles are born and then die-off fast these days. Companies, just like investment strategies, have shortening half lives and depend on ongoing innovation to keep performing. When AOL got added to the S&P 500 I got heavily short, selling to the index trackers, yet every broker I gave the order to said I was crazy as it was "obvious" AOL was going to "own" the internet. Turned out to be almost exactly the top. There can be no buy and hold when the commercial and technological environment changes so quickly. Today's up and comer no brainer buy is tomorrow's short sell.

Ten years from now we may have trouble remembering that Facebook ever existed. Meanwhile Google is more likely worrying about tiny internet startups, not Microsoft-Yahoo, otherwise in 2018 people will be asking what was the name of that stock investors got excited about back in the 00s? Goggle.com or was it Googol.com? Something like that. When was the last time you searched on Excite or Altavista, but both were major players not so long ago. Netscape was once the hottest stock around. You can't be passive when the investment opportunity set is so active.

The Dow Jones Industrial Index just took the active investment decision to bet on Bank of America (BAC) and Chevron (CVX). The Dow is supposed to be representative of the broader economy and banking and energy already had a fair weighting. Investing 101 says to keep your winners so dumping last year's best performer Honeywell (HON) seems a tad unfair. Even harsher is getting rid of Altria (MO) when it has been the best Dow performer over decades.

If it had been up to me I would have added Berkshire Hathaway (BRK.A) and Google as both have larger capitalizations than BAC or CVX and bring more diversification to the mega cap index. Dow Jones would probably argue that BRKA is too illiquid and GOOG too "new" but the real reason is that with the absurdity of price weighted indices, GOOG would have comprised 27% while BRKA would be over 99% of the Dow at current prices! How silly to limit the world's best known market metric to only those stocks priced not too high and not too low. I would have thought that value and market cap would be more appropriate. And why should illiquidity be an exclusion criterion for what is supposed to be a long term buy and hold benchmark?

There is a notion that most equity indices are passive when each addition and subtraction is an active choice. I have very accurate point in time and dividend data going back to 1896 and just spent my time in Alaskan airspace looking at the Dow's worst ever trades. Chevron first got added back in 1924 and it might have been better to leave it in throughout. Back in the 1930s, they added Coca Cola (KO) and IBM (IBM), deleted them a few years later and then re-added them more recently after MISSING several decades of exponential growth. If those two stocks had been left in throughout, as best I can figure, the Dow would be somewhere around 26,000 today.

But can you blame the Dow for deleting such obvious "losers" at the time? Selling overly sugared soda during the depression? Manufacturing international business machines when the future CEO estimates market demand for five computers and most of "international" are preparing for war? Not very persuasive business models at the time. Conversely it is not so long since blue chips like Bethlehem Steel and Woolworths FL were in the Dow and look what happened to them. Long/short means buying good stocks and shorting bad stocks; is that so dangerous? Is long only really "safer" than long/short investing?

I would have thought that prudent investing would require funds to be managed by full time stock pickers with NO other duties. I am sure Marcus Brauchli is a fine managing editor at the Wall Street Journal but how does that leave him time for equity research? The recent changes in the Dow do NOT "fully reflect the market". Are BAC and CVX really better additions than BRKA and GOOG? I realize MO is basically a stub now but Honeywell is right to be miffed just like the bizarre dropping of International Paper (IP) last time around. Far more money tracks the S&P but the only index likely to be followed by Mom and Pop is the DJIA so it should be as "representative" as possible.

Even the Dow "original", General Electric (GE), has been actively added and deleted. Whether it is the Dow, S&P, MSCI, FTSE, Nikkei, Hang Seng, they are all managed ACTIVELY mostly by newspaper publishers. There is no passive as index components go bankrupt, fall by the wayside or get bought out; an ACTIVE decision has to be made as to what the replacement will be. As barometers and benchmarks these indices have use, but to actually invest in them? Real money stock picking is best left to those with an informational edge and vocation in doing that stock picking.

The only style of investing that exists is ACTIVE investing. It may be the decades outlook of Warren Buffett and the DJIA stock pickers or the milliseconds of an ultra high frequency statistical arbitrage strategy, but regardless of holding period, it is an active investment decision making. The only indices that make sense to me are those that minimize stock picking subjectivity. The Nasdaq and TOPIX include the performance of EVERY stock on their respective exchanges; they are still active since the components change but at least they are closer to what an index should be.

Whether an equity index will go up is conjecture. That some stocks go up and others go down is a certainty. Given that active investing is the only choice available, it would seem to be the best course of action is to hire the managers with the most dedication, skill, talent and incentives to figure out which stocks to short and which to buy. Economic conditions, products, consumer trends, corporate agility and geopolitics changed rapidly last century and even more so in this one. How can passive succeed in such an active environment?

Hedge funds outperformed in January and a third made money, unlike the 100% of "passive" indices that lost $5 trillion of investors' hard earned cash. I don't know where people get the idea that January was "difficult and challenging" when it offered so much opportunity and volatility. Short and short again. One aspect missed by some about short selling is that as the price moves down, you must do more short selling just to maintain the constant portfolio percentage. Stock indices might or might not go up but many more individual stocks go to zero than infinity. I wrote in early December how "short only" was probably going to be "the" strategy for 2008, though I reserve the right to change my mind! The only way to survive in finance is to be active and adapt.

There is no inherent return from "stocks" OR "real estate" anymore than "hedge funds". It is naive at best, dangerous at worst, to "expect" to be compensated with risk premium. So next time your real estate broker tells you houses "always" eventually hold their value or your stock broker/financial advisor/wealth manager/private banker asserts that stocks will go up over long holding periods, ask them the following:

"I appreciate your expertise and would like to be an even more profitable client for you. Since you assert that over 30 year holding periods risky asset classes MUST outperform, you are implicitly assuming that a 30 year at-the-money put has zero value. I will therefore pay you $1 premium for each $1 million notional of ultra long LEAPS 30 year puts you sell to me. You can choose the index, Dow, Dax, NAREIT whatever. There is "no" risk for you since you believe the stock market will be much higher in 2038 and the options will therefore expire worthless. Please let me know what collateral you have in the extremely unlikely "impossible" tail risk event that I exercise the put."

Whatever scenario happens there is only active decision making. Society and markets adapt so portfolios must adapt to them. It is staying agile and innovative and keeping up with new opportunities that sorts the alphas from the betas. Markets morph, factors fluctuate and drivers deviate. In any space, the passive becomes extinct while the active thrive. Best wishes for the Year of the Earth Rat 4706; it looks like it will be a great year for active alpha no matter what happens in the world financial markets.

Comments

[Malkiel:]

Is this some kind of pep talk for readers of some newsletter? There are two kinds of writers: those who talk and those who know what they're talking about. All this stereotyping imagery is a bunch of intellectual fluff with no substance: tough minds might ask how the sloths and turtles have been around longer than all your swift creatures listed above (including a mythical one that never existed, the dragon) if they're so ill-adapted? Lazy researchers who are good observers may outperform all your frantic alpha-researchers. Got an image for that?

2008 Feb 14 12:28 PM

[User 138049:]

well since the chinese zodiac is cyclical, wouldn't there be no first and no last? Its like asking the question which came first - the recession or the boom?

2008 Feb 15 12:39 PM

[vitaminc:]

"Today's up and comer no brainer buy is tomorrow's short sell. "

By your logic, GOOG is a perfect short in the Internet space. And yet instead you been pumping GOOG in the whole article.

2008 Feb 16 11:14 AM

[Cecil:]

This article starts out well enough, but veers sharply off course and ends up in some kind of bizzaro-world of alpha rats and 30 year puts. Could you just come up with a theme, and stick to it? It would be so much more interesting for the reader!

2008 Feb 23 05:58 PM