A piece appeared in the Financial Times this weekend titled “Passive parasites do not cure all financial ills.” Written by David Smith, a mutual fund manager in the UK, the piece make two common attacks on passive investment philosophies.
1) The “Logical Extension” argument. This typically centers around a statement that the markets don’t work if everyone just buys an index fund. We need individuals and professionals to be engaged in the trade of stocks and bonds to set efficient prices for those securities. I do not know any advocate of passive investing who would argue we need no financial intermediaries or people to trade stocks and bonds. However, the current marketplace is swarming with these intermediaries, very few of whom can add value for individual investors. This slippery-slope fallacy is an easy go-to for fund managers trying to defend their livelihood. The simple fact is this: net of fees, individual investors who invest in low-cost index funds will have a better probability of reaching their goals than those in active funds. There is some good recent research by Rick Ferri on this as well.
2) The “Markets Aren’t Rational” argument. Smith attacks the Efficient Market Hypothesis by noting that investors do not behave rationally. He says “…it must surely be possible for active managers to take advantage” of irrational markets. I’ve already taken this argument apart, so I won’t rehash it here. The short answer is: of course markets are irrational, but there is zero evidence that active managers have been able to translate this irrational behavior into market-beating returns.
Here’s the thing that is always true in the active vs. passive management debate: one side comes armed with narratives and could/would/should statements, and one comes with tricky things like facts and data. It’s up to investors to decide which is more worthy of their attention.