The Case Against Passive Investing

by: EB Investor


It is no secret that the asset flows have been shifting recently from active to passive strategies.

I believe investors are making a serious mistake and once again are not learning from history.

The merits of active management are well documented even if they are drowned out by the hysteria of passive investors.

I still believe that investors utilizing a disciplined investment process can handsomely outperform the index over time.

I will go through the evidence for why I believe active investment management is superior to index investment strategies.

Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.
Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds

The Problem with Index Funds

The problem with index funds and the efficient market hypothesis on which they are based is that it fails to conform to the real live data set. In the real world, markets do not move in nice linear patterns, they move irrationally up and down. The advisor touting index funds tells you to always keep investing, not caring about price or value of the asset you are investing in. All the while not realizing the mathematical reality that one single extreme event can wipe out decades of investment gains. For example, an investor in the S&P 500 index saw more than 10 years of gains wiped out in the Fall of 2008.

Many would make the argument that the world is back to normal now, and the markets are at all-time highs. Yet I would point to the mathematical distribution pattern throughout the ages which tells us that what goes up must come down. Given the vast government involvement in the current market by the Fed pumping markets to all-time highs, mathematics tells us that at some point in the future the completion of this market cycle will again wipe out years of investment gains driven by low interest rate debt used to fund share buybacks and dividends. Active management of risk seeks to preserve gains and put less and less capital at risk. That is why it is important to be an active investor.

Index fund investing is built on the premise that markets are efficient and thus active management is a high priced activity without results that is not worth your money. The indexer builds his entire portfolio and stakes his financial future on the notion that markets are efficient. Yet evidence clearly disproves this contention and demonstrates markets are inefficient. The principles of Graham & Dodd value investing have endured these many decades and will continue to endure. In this piece, I will explore the efficient market hypothesis and reiterate the merits of active management, and why I believe index investing is an ineffective way to invest.

In an article on the front page of Tuesday's Times, Binyamin Appelbaum did a nice job of highlighting the difference in views between Robert Shiller and Eugene Fama, who shared this year's economics Nobel memorial prize with Lars Peter Hansen. But there's a danger that some readers may come away from the article, and other news coverage of the prize, with the impression that the issue of whether financial markets are efficient remains unsettled. It isn't. After living through a stock-market bubble and a credit bubble in the past decade and a half, we can be quite sure that financial markets are sometimes chronically inefficient.

- John Cassidy - New Yorker

Understanding Active Investing

In many of my pieces, I have articulated my views on real active management, and how investors can put the odds in their favor. I have made a distinct differentiation of active management separating the strategy into three basic categories.

  1. Closet Indexers
  2. Speculators
  3. Real Active Managers

Closet Indexers

Closet indexers are those purporting to run active funds, but instead running index-like products at much higher fees. These funds tend to not take the fiduciary duty to shareholders seriously, almost never closing to new investors when asset levels threaten the integrity of the strategy. These funds tend to have little to no manager ownership and act as asset aggregators for their firm. The funds tend to have high expense ratios and may also have higher turnover than traditional indexes, adding additional costs to their owners.


Speculators are easy to spot, they generally have obscenely high turnover, high costs, and think in months or even weeks, turning over their portfolio at every news headline or new idea. They constantly try to create alpha through market timing and their method has been shown to have a poor record for the long run.

Real Active Managers

Real active managers are not very active at all. These funds generally have high management ownership, very low turnover, and reasonable cost structures. The mangers of these funds take their fiduciary duty seriously and are willing to close a fund to preserve the strategy for existing, long-term shareholders. These managers follow a research-based methodology that attempts to uncover undervalued assets, or growth at a reasonable price and hold them for the long run. Research has proven this is the best way to invest.

Index Marketing Can Be Hazardous to Your Wealth

The father of passive investing and the creator of the first index fund, John Bogle, begins his book "The Little Book of Common Sense Investing" with a tale about the "Gotrocks Family" who owned all the common stocks in the country, yet whittle away their advantage by hiring high priced managers and investment consultants when in reality they should just stick with the low cost of owning the whole market.

The entire tale paints those "helpers" as the evil swindlers seeking to rob the family of their hard earned wealth. While I have great respect for the author, and think he has done much for the individual investor, this story does not do much to illuminate the world of investing nor explore the research behind the contentions of those defending the efficient market hypothesis upon which index fund investing is dependent.

You will hear a great deal in index marketing literature such as this about the evils of the "helpers" known as financial advisors and investment managers and consultants. While it is true that there are a percentage of the population of those who call themselves financial advisors, managers or consultants, that do not have your interest at heart, there is also a vast number of financial professionals who truly want to help people make sense of their financial lives. I have had the great privilege over my career of meeting many highly qualified financial professionals who are true investors, aiming to attain the highest total return and trying to do what is right for clients in all matters. These helpers, as the story derogatorily refers to them, largely do just that, they help make sense of a complicated marketplace.

Investors have so many decisions to make concerning how to invest for the future, whether to use active or passive management, whether to include alternative assets or not, how much to allocate to stocks and bonds, and which stocks or bonds to buy. All of these questions cause many investors to sit still, not trusting their ability to make these decisions alone, and fearing the financial advisory community because of the marketing hype of passive investors who claim you should just ditch that financial advisor and those "high priced" active strategies and index your way to wealth.

I believe the notion that investors should just buy index funds is poor advice which I analyzed in my piece, Don't Buy Index Funds. This false mantra of the superiority of indexation has been built on the core belief that the stock market is efficient and therefore attempting to find an advantage in the capital markets through securities analysis is a fool's game. But what if this core belief upon which everything else is built, is in fact false?

How Efficient Are Markets?

The efficient markets hypothesis - EMH - of Fama and French is the prevailing standard theory explaining the behavior of markets and the determinant of the market pricing mechanism for academic finance today. It draws largely on the theories of Markowitz, Sharpe and many other academics who have sought to explain the movement of market prices. Noted passive investor and author of the investing classic, "A Random Walk Down Wall Street", Burton Malkiel refers to the movements of the market as a random walk, with prices moving efficiently, responding to new information instantaneously. Fama has even gone so far as to claim that bubbles do not exist, or cannot exist, because prices are always correct.

While the research of the aforementioned academics is considered the core theory on market pricing, those who subscribe to this belief system are ignoring volumes of academic research to the contrary. I have found that the main differentiator between an EMH apologist and an active investor is openness to information. Most of those who believe in EMH do so to the exclusion of all other research, believing that the EMH is correct and the notion of market pricing is settled; they are right and you are wrong if you disagree. The reality is that there is a great deal of evidence to demonstrate that markets are not efficient, and a more balanced perspective to markets and portfolio construction is warranted.

The Evidence For Market Inefficiency

Figure 1 & Table 1 From Excess Returns

The evidence for market inefficiency is vast though completely ignored by index advocates. " Published in 1970, the definitive paper on the efficient markets hypothesis is Eugene F. Fama's first of three review papers: 'Efficient capital markets: A review of theory and empirical work' (Fama, 1970). He defines an efficient market thus: 'A market in which prices always "fully reflect" available information is called "efficient."'

Fama's requirement for markets to "always" "fully" reflect available information makes the theory most certainly false in an absolute sense. Many academics from finance, economics and mathematics have disproven the theory of an efficient market, yet index advocates continue to insist that markets follow a random walk and are largely efficient, making securities analysis a fruitless activity.

In reality, the evidence supports the conclusion that markets are largely inefficient creating significant opportunities for those operating with a Graham and Dodd value philosophy to outperform the market over the long run.

The following is just a sampling of the academic studies that reject the notion of market efficiency and support the notion that when you control for certain variables such as cost, turnover, etc., active management can net investors significant performance advantages over market indexes.

  • In 1977, M. F. M. Osborne published, The Stock Market and Finance From a Physicist's Viewpoint, a collection of lecture notes, in which he discusses market-making, random walks, statistical methods and sequential analysis of stock market data (Osborne, 1977).
  • Beja (1977) showed that the efficiency of a real market is impossible.
  • Sanford J. Grossman and Joseph E. Stiglitz (Grossman and Stiglitz, 1980) showed that it is impossible for a market to be perfectly informationally efficient. Because information is costly, prices cannot perfectly reflect the information which is available, since if it did, investors who spent resources on obtaining and analyzing it would receive no compensation. Thus, a sensible model of market equilibrium must leave some incentive for information-gathering (security analysis).
  • LeRoy and Porter (1981) showed that stock markets exhibit 'excess volatility' and they reject market efficiency.
  • Stiglitz (1981) showed that even with apparently competitive and 'efficient' markets, resource allocations may not be Pareto efficient.
  • Shiller (1981) showed that stock prices move too much to be justified by subsequent changes in dividends, i.e. exhibit excess volatility.
  • In 1985, Werner F. M. De Bondt and Richard Thaler (De Bondt and Thaler, 1985) discovered that stock prices overreact, evidencing substantial weak form market inefficiencies.
  • Lo and MacKinlay (1988) strongly rejected the random walk hypothesis for weekly stock market returns using the variance-ratio test.
  • Shiller (1989) published Market Volatility, a book about the sources of volatility which challenges the EMH.
  • Laffont and Maskin (1990) show that the efficient market hypothesis may well fail if there is imperfect competition.
  • Lehmann (1990) found reversals in weekly security returns and rejects the efficient market hypothesis.
  • Jegadeesh (1990) documented strong evidence of predictable behavior of security returns and rejects the random walk hypothesis.
  • Kim et al. (1991) re-examined the empirical evidence for mean-reverting behavior in stock prices and found that mean reversion is entirely a pre-World War II phenomenon.
  • In 1995, Robert Haugen published the book, The New Finance: The Case Against Efficient Markets. He emphasizes that short-run overreaction (which causes momentum in prices) may lead to long-term reversals (when the market recognizes its past error) (Haugen, 1995).
  • Campbell et al. (1996) published their seminal book on empirical finance, The Econometrics of Financial Markets.
  • Chan et al. (1996) looked at momentum strategies and their results suggest a market that responds only gradually to new information.
  • Lo and MacKinlay (1999) published A Non-Random Walk Down Wall Street (arguing for market inefficiency.)
  • Haugen (1999) published the second edition of his book, which makes the case for the inefficient market, positioning the efficient market paradigm at the extreme end of a spectrum of possible states.
  • Bernstein (1999) criticized the EMH and claims that the marginal benefits of investors acting on information exceed the marginal costs.
  • Shleifer (2000) published Inefficient Markets: An Introduction to Behavioral Finance, which questions the assumptions of investor rationality and perfect arbitrage.
  • Shiller (2000) published the first edition of Irrational Exuberance, which challenges the EMH, demonstrating that markets cannot be explained historically by the movement of company earnings or dividends.
  • Lee et al. (2010) investigated the stationarity of real stock prices for 32 developed and 26 developing countries covering the period January 1999 to May 2007 and concluded that stock markets are not efficient.
  • Wermers (2000) "Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses" found that "funds pick stocks well enough to cover their costs" and concludes, "Our evidence supports the value of active mutual fund management."
  • The great mathematician Benoit Mandelbrot taught at Harvard University and finished his academic career as the Sterling Professor of Mathematical Sciences at Yale University. His renowned research touched nearly twenty different areas of study from physics to the financial markets though he is best known for his work in fractal geometry.
  • In his book, "The (Mis) Behavior of Markets", Dr. Mandelbrot sought to test whether asset prices indeed follow a random walk. To do this, he compared the volatility of the Dow Jones Industrial Average since 1916, and compared it to the market volatility of the same market operating in an efficient priced random walk. He found that the results disproved the efficient market hypothesis.
  • James O'Shaughnessy takes the Mandelbrot study even further in his classic, "What Works on Wall Street", where he extends the study back to 1896.

With daily index levels for the DJIA going back to 1896, we are able to extend his study even further back. Figure 3.3 represents the daily volatility (measured in standard deviations) of an efficient-or random walk-market. Notice that the days follow a normal distribution pattern, with very few days exceeding four standard deviations of the average change. This would be the sort of market which proponents of the efficient market hypothesis argue makes it so difficult for investors to outperform.
Figure 3.4 is the actual daily market volatility of the DJIA back to 1896. There are many observations between 5 and 10 standard deviations, and one in 1987 that exceeds 20 standard deviations. As Mandelbrot points out, the odds of Black Monday happening in an efficient market framework are one in 10^50. If markets were indeed fully efficient, the Dow could have traded every day since the big bang and we still would not expect to see a day like Black Monday. It should alarm investors that tools which are meant to help us quantify risk, such as Value at Risk and options pricing models like Black-Scholes assume that markets move randomly, as in Figure 3.3. Real market history is so at odds with the random walk assumption that this evidence represents a fatal blow to the idea of perfectly efficient markets.

What Works on Wall Street

Random Walk-Efficient Market DJIA Volatility Figure 3.3

Actual DJIA Volatility Figure 3.4

Finally, every investor should read the piece, "The Active Equity Renaissance: The Rise and Fall of MPT" by C. Thomas Howard, on the CFA institute blog, it gives a great summary of the rise and fall of accepted dogma within the financial community and makes a call for evidence and rationality in a world of emotional decision making. In my favorite section from the piece, the author states:

Much of finance pushes aside the mounting contrary evidence and soldiers on under the yoke of the MPT paradigm. This might seem surprising: Isn't finance a discipline based on empiricism, one that only accepts concepts supported by evidence? Unfortunately, as Thomas Kuhn argued years ago in his classic work, The Structure of Scientific Revolutions, scientific and professional organizations are human and are susceptible to the same cognitive errors that afflict individual decision making.

-C. Thomas Howard

Investors are making a huge mistake getting rid of active managers and pouring into total market index funds, with the market at current levels especially. With a little due diligence, it is more than reasonable to conclude that one can select quality investment managers who can provide a low cost, risk conscious, total return approach to investing that will allow investors to reach their long-term goals. Throwing this away for the promise of matching market returns will only be sure to disappoint you and may turn out to be hazardous to your long-term wealth accumulation and preservation goals.

Index funds provide investors with maximum risk and guaranteed below average returns. While we can agree certain "smart beta" indexes have their place within a larger portfolio model for the right investor, relying solely on a total stock market index fund, and going it alone, is not in an investor's best interest. Working with a qualified wealth manager, who acts as a fiduciary and has an investor's best interest at heart, can provide investors with a superior overall wealth management strategy than can be accomplished with index funds, built on the failed notion that markets are efficient.

An Example of the Value of Active Management

To test the value of an active Graham & Dodd Value approach to investing, we are going to look at two investors. The first is going to invest all their money in the MSCI World Index, the second in the Tweedy Browne Value Fund.

Globally diversified Index investors such as those in the MSCI World Index who had the misfortune of retiring in 2008 saw their nest egg get cut nearly in half reducing a $1 million retirement portfolio to a mere $578,100, a 42.19% reduction. Even worse it took five years just to get back to even, and still eight years after the financial crisis and the subsequent massive drawdown that cut a retirement investor's portfolio nearly in half, this globally diversified index investor has a balance today of a mere $1,270,955.91, not adjusted for inflation, providing a total return of 27.1% over eight years.

An investor in the Tweedy Browne Value Fund (MUTF:TWEBX) whose primary benchmark is the MSCI World Index, on the other hand, was able to avert the worst of the financial crisis, and saw their balance reduced by a mere 24.37%, to $756,300, and got back to even within two years. Eight years later this investor's portfolio is worth $1,566,120.89, a total return of 56.61%. As you can see in the chart below, the U.S. centric investor who invested only in the U.S. saw an even greater alpha capture from active management than the globally diversified investor. Capturing less of the downside and more of the upside, an active U.S. investor saw their investment in the Mairs & Power Growth Fund (MUTF:MPGFX) more than double over the past eight years, while the Vanguard Total Stock Market Index Fund (MUTF:VTSMX) investor captured more of the downside, taking four years to get back to even and achieving a lower total portfolio balance over the full time period.

Global Investor 2008 2009 2010 2011 2012 2013 2014 2015 2016
$1,000,000.00 $578,100.00 $778,296.03 $876,906.14 $812,453.54 $943,502.29 $1,158,620.81 $1,206,819.44 $1,178,338.50 $1,270,955.91
MSCI ACWI -42.19% 34.63% 12.67% -7.35% 16.13% 22.80% 4.16% -2.36% 7.86%
TBGVX -24.37% 27.60% 10.51% -1.75% 15.45% 22.68% 4.02% -7.51% 9.69%
$1,000,000.00 $756,300.00 $965,038.80 $1,066,464.38 $1,047,801.25 $1,209,686.54 $1,484,043.45 $1,543,702.00 $1,427,769.98 $1,566,120.89
U.S. Centric Investor 2008 2009 2010 2011 2012 2013 2014 2015 2016
$1,000,000.00 $629,600.00 $810,295.20 $948,774.65 $957,882.89 $1,113,538.86 $1,484,904.06 $1,669,477.64 $1,674,319.12 $1,884,111.31
VTSMX -37.04% 28.70% 17.09% 0.96% 16.25% 33.35% 12.43% 0.29% 12.53%
MPGFX -28.51% 22.52% 17.40% 0.74% 21.91% 35.64% 8.12% -3.07% 15.38%
$1,000,000.00 $714,900.00 $875,895.48 $1,028,301.29 $1,035,910.72 $1,262,878.76 $1,712,968.75 $1,852,061.82 $1,795,203.52 $2,071,305.82

To illustrate the risks investors are taking with index funds, if we extend this study for the U.S. investor back to the turn of the century, we see that an investor in the Total Stock Index turned their $1 million retirement portfolio into a mere $2,375,054 over the past 17 years, while the active investor in MPGFX would have a balance of $4,776,535. In my view, index investors are taking far more risk than they realize and in the process are putting their long-term goals in jeopardy.


One final story comes from a recent issue of the New York Times who wrote an article about Vanguards exceptional growth. They state:

The triumph of index fund investing means Vanguard's traders funnel as much as $2 billion a day into stocks like Apple, Microsoft and Amazon, as well as thousands of smaller companies that the firm's fleet of funds track. That is 20 times the amount that Vanguard was investing on a daily basis in 2009... through February of this year, nine out of every 10 dollars invested in a United States mutual fund or ETF was absorbed by Vanguard.

This should concern all market participants. Forget the systemic risks presented by one company controlling such a large piece of the country's citizens wealth, how do people consider it a wise way to invest to mindlessly shovel money into companies based on market-cap without any consideration of valuation? Index investors fail to see stock for what it is; a share of a corporation. The price you pay values the companies future cash flows, when participants ignore the price paid for those future cash flows, they put themselves squarely outside of the world of investing and enter the world of speculation.

When the next financial crisis comes and markets wipe out trillions of dollars in wealth and people ask how could the market get so overvalued? The rapid transition to index mutual funds will undoubtedly be named as a culprit. Bidding prices higher and higher as money gets mindlessly shoveled into companies without any regard for their fundamentals is a recipe for disaster.

In conclusion, I have presented the evidence against the efficient market hypothesis, and against relying on index funds to accomplish your long-term goals. While the arguments of index marketing may be appealing, the evidence does not support the contention that the market is efficient, thus dimming the view that index funds are appropriate investment vehicles. While not all index funds are bad, and they do have their place in certain asset classes, as part of a long-term diversified portfolio, the vast majority of an investor's wealth should be allocated with their specific goals in mind leaving practitioners open to active and passive strategies.

The index crowd wants to push everyone into a one size fits all index fund portfolio. I believe that the approach to managing your wealth should be as unique as you are. There is no one size fits all solution to achieving your long-term goals. It deserves a thoughtful approach with you at the center and utilizing the best investment solutions for your unique goals. That is why I believe in active management. There is a reason that 82% of DFA funds have beaten the market. Tilting one's portfolio towards the sources of outperformance has been proven to be superior to index fund investing. In my next piece, I will make the case for evidence-based investing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.