In our previous post, we pointed out features of mutual funds which can act as an obstacle to following the Taylor Frigon dictum of building future wealth upon a foundation of the ownership of successful business enterprises benefiting from capable and dynamic management operating in a future field for fertile growth, and owning them over a long period of years.
This discussion naturally brings up the debate over indexing or what has been called "passive management," because a large number of investors who do realize the drawbacks of mutual funds use those drawbacks as arguments in favor of investing in index funds or other vehicles designed to capture a market or portion of a market.
At the very outset of the discussion, we should note that using the drawbacks of mutual funds as an argument for passive management is illogical, because (as we have argued) the drawbacks to mutual funds stem from the ways in which they impede the investor's ability to own exceptional companies for a long period of years. Running from a vehicle that impedes such ownership to a vehicle built on the outright rejection of the concept of ownership of exceptional companies is not a logical move.
Many index fund backers and other passive management supporters do not have the background in selecting companies which would enable them to see that the problems with mutual funds are primarily related to the extent to which they impede ownership of exceptional companies for long periods of years.
We explained previously that advocates of passive management (such as Vanguard founder John Bogle, pictured above) argue for the ownership of markets rather than the ownership of businesses, in posts such as this one and in our commentary entitled "The Emperor's New Index Fund."
Advocates of passive management often adopt a very condescending attitude towards the very concept of trying to select superior companies, arguing that the issue has been settled beyond doubt. An example of such condescension is found in this reproduction of the opening arguments in an active vs. passive debate which took place in 1995. It is a good example of those arguments, touching on most of the main points used by advocates of passive investing.
The author of that piece, Rex Sinquefield, not only argues that academia has proven beyond any shadow of doubt that belief in active management is simply "no longer a credible position," but also goes so far as to co-opt the economic triumph of free-market capitalism over central planning as an argument for passive management! He does so by implying that active management is somehow a rejection of the idea that "markets work" and that anyone who believes -- along with Adam Smith and Friedrich Hayek -- that markets do work should ipso facto be an advocate of passive investment.
In fact, he jokes that the only people who still disagree with Smith and Hayek are "the North Koreans, the Cubans, and the active managers."
But, which is more aligned with the principles of free-market capitalism: the idea of allocating capital to successful business enterprises, or the idea of allocating capital indiscriminately to all businesses in a blanket fashion? As we have argued elsewhere, in free-market societies, most people do not allocate their own "human capital" by indiscriminately working for any business in any industry as if one is just as good as another (Sinquefield himself did not do so). Why would they allocate their financial capital that way?
Furthermore, opponents of active management often describe active management as being dependent upon finding bits of information before the market has time to react to those bits of information, trading on inefficiently-distributed information before the market has time to adjust. While this kind of behavior is what many think of as "investing," we have argued that this picture of investing is not the whole picture (although Wall Street and the financial media tend to reinforce that point of view).
The classic investment philosophy we have described in previous posts, and that was practiced in previous decades by Dick Taylor and Thomas Rowe Price, was not based on any such attempts to "dip and dart, pick stocks and time markets" as Sinquefield describes. It is not based on an attempt to exploit temporary inefficiencies or unknown information, but rather upon the long-term superiority of business fundamentals to market-timing schemes. It also accords very well with the principles of Adam Smith and Friedrich Hayek.
As for the very common assertions made by advocates of passive management that "all studies to date" show no evidence that any strategy can be better than owning markets, consider any list of the wealthiest Americans published this year or in previous years going back for about a century, and ask yourself how those individuals became that wealthy. Did any of them achieve their great wealth through a system advocated by promoters of passive investing, or was it rather through a process that more closely resembles "the ownership of successful business enterprises that continued to grow and prosper over a long period of years"?
In the same 1973 tract in which he explained his Growth Stock Theory of Investing, Mr. Price also published the results of his portfolio from 1934 through 1972. Over the course of those forty-two years, the increase in market value of his portfolio was at a compound annual growth rate (CAGR) of 11.9% per year, versus the Dow Jones Industrial Average's CAGR of 6.2% per year. The dividend increase of the Dow over the same period was 5.4%, versus 9.4% for Mr. Price's portfolio. Advocates of passive management dismiss any out-performance by some managers as "nothing more than one would expect by chance" (to use the phrase of Mr. Sinquefield). However, it is difficult to argue that the record Mr. Price achieved following his method of selecting well-run businesses in front of fertile fields of growth was a "chance" anomaly that persisted for a period of over four decades!
Finally, it must be noted that index or ETF investing in practice often boils down to owning this slice of the market and then that slice of the market and thus "market-timing" in the very way that Sinquefield eschews, dipping and darting and picking and timing but doing so by picking "sectors" or "capitalizations" or other large groupings rather than individual stocks.
Investors today will encounter many arguments that present the superiority of passive management as an unassailable fact. However, we would caution investors not to be too easily dissuaded from the sound principle of ownership of businesses.
For later posts dealing with this same topic, see also:
- "The zero-sum connection" 06/02/2008.
- "Beautiful growth companies, part III" 05/13/2009.
- "S&P takes aim at active management" 10/07/2009.
- "The best defense is a good offense!" 12/03/2009.
- "Composite performance through 12/31/2009" 01/11/2010.
- "Free markets, free enterprise, Friedrich Hayek, and active allocation of investment capital" 07/13/2010.
- "Does a rising tide really lift all boats?" 07/20/2010.
- "The dance of the hippos" 08/10/2010.
- "The growth theory of investment works" 01/14/2011.
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