the ongoing "active" vs "passive" debate

Asset allocation, risk, diversification and rebalancing. Pros/cons of hiring a financial advisor. Seeking advice on your portfolio?
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Bylo Selhi
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Re: the ongoing "active" vs "passive" debate

Post by Bylo Selhi » 26 Oct 2013 12:46

David Moenning further wrote:Since 1995, assuming no trading costs, the hypothetical trend-following system would have shown a return of 555.6 percent while the buy-and-hold approach would have sported a return of 281.5%. Not bad, eh?
[my bold]

Moenning's frictionless world also allow for perpetual motion machines and other such fantasica :roll:

Indexers don't claim that active managers can't beat the market. Indexers claim that active managers can't do it after costs, including transaction costs, taxes, manager remuneration, etc. Moenning has provided nothing to disprove that claim.
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Re: the ongoing "active" vs "passive" debate

Post by DmDave » 26 Oct 2013 14:46

I'm a firm believer of passive investing after diving into it early this year. I've read a lot of books over this past year, from "Random Walk down Wall St", "Four Pillars", to "Winning the Loser's Game", pretty much convinced that I can't shoot the lights out with my stock picking skill, or any fund manager's skill. And I'm not smart enough to go and question Nobel Price winners.

Even if a person has a strategy that beats the market over the long term, what is the tax consequence? I have yet to read about anyone successfully jumped out of US stocks in 2008, and jumped back in in early 2009, right after the bottom.

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Re: the ongoing "active" vs "passive" debate

Post by ockham » 26 Oct 2013 14:48

Bylo Selhi wrote:
David Moenning further wrote:Since 1995, assuming no trading costs, the hypothetical trend-following system would have shown a return of 555.6 percent while the buy-and-hold approach would have sported a return of 281.5%. Not bad, eh?
[my bold]

...Moenning has provided nothing ......
This bold captures my view. We already knew from Sharpe's simple market arithmetic that for any time period, some active managers will outperform. That bit of simple arithmetic combined with a bit of ingenuity will enable the defining of any number of strategies which, had they been followed, would have resulted in outperformance over that time period. So far, so good.

The dirty secret is that the same simple arithmetic combined with the same ingenuity will define strategies which, if followed, would have underperformed. That what makes the market. And telling in advance which will be which for the time period that matters to my investing time frame is not so easy (or should I say, impossible).

Canadian Couch Potato (if memory serves) had a piece not long ago that argued that, when times are bad, alpha seeking investors are less likely to be able to remain true to a strategy than are passive indexers. The idea was that if being truly passive is hard, sticking to a strategy while active is harder still.

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Re: the ongoing "active" vs "passive" debate

Post by ghariton » 26 Oct 2013 20:57

ockham wrote:We already knew from Sharpe's simple market arithmetic that for any time period, some active managers will outperform.
Indeed. We know that, before fees and on a market-cap-weighted basis, half will over-perform and half will under-perform. After fees, well, just randomly, some will over-perform while the vast majority will underperform.

The more interesting question is predicting which ones will over-perform, net of fees. There are systems for predicting that. But then there are systems for predicting winning lottery tickets. And they work -- sometimes.

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Re: the ongoing "active" vs "passive" debate

Post by parvus » 26 Oct 2013 21:29

Doesn't necessarily require a system. Just following a defined set of rules. Whether rules-based investing is passive I will leave to you.

Naturally, there will be frictional costs for rebalancing and capital gains. But there are frictional costs for market-cap weighting too, namely having to add new index components, or, if a total market approach, illiquidity costs.

Perhaps the thread really should be about market-cap weighting, yeah or nay? Why, because it applies to both passive and active approaches, given that many active managers are closet indexers.

Since I don't really believe in efficient markets (I know, I know, neither does Bogle), I like to look at rules-based approaches that avoid, or at least temper the temporary momentum effects of market-handicapping, where a few stocks can become 30% or more of your market. There goes your diversification.

Thus, I'm intrigued by equal-weight and fundamental approaches, providing they can be had relatively cheaply.
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Re: the ongoing "active" vs "passive" debate

Post by newguy » 26 Oct 2013 22:56

ghariton wrote:
ockham wrote:We already knew from Sharpe's simple market arithmetic that for any time period, some active managers will outperform.
Indeed. We know that, before fees and on a market-cap-weighted basis, half will over-perform and half will under-perform.
No, it means I'll outperform and the rest of you suckers will give me all your money. :wink:

Nothing from Sharpe contradicts me. Just think what it means when they say ~90% of traders lose money. It means the other 10% are getting all of it.

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Re: the ongoing "active" vs "passive" debate

Post by parvus » 26 Oct 2013 23:27

ghariton wrote:
ockham wrote:We already knew from Sharpe's simple market arithmetic that for any time period, some active managers will outperform.
Indeed. We know that, before fees and on a market-cap-weighted basis, half will over-perform and half will under-perform. After fees, well, just randomly, some will over-perform while the vast majority will underperform.
Yes well, that's around the median. Doesn't tell us much about the average though, does it? :wink:

(I'm speaking to newguy's point.)
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Re: the ongoing "active" vs "passive" debate

Post by ghariton » 26 Oct 2013 23:29

parvus wrote:Thus, I'm intrigued by equal-weight and fundamental approaches, providing they can be had relatively cheaply.
On equal-weight approach, presumably you have to draw boundaries. All stocks traded on the TSE? Do you include all stocks traded on Ventures as well? OTC? Market cap weighting solves the problem in practice, because the small companies can effectively be ignored, or sparsely sampled.

But if your index is equal weights, can you sample? If so, on what basis? If it is truly equal weights, is it the chimp's darts board, computerized? Or do you truly have to buy a piece of every company, even the very small ones? And if it is the latter, and a large number of investors opt for equal weights, will a whole bunch of funds be bidding for the same small companies? If so, won't that drive up their share price to stratospheric levels? Or does equal weights work only if a small fraction of investors adopt it?

On fundamental indexes, if many investors opt for the same fundamental index, that will drive up the share price of smaller companies with attractive fundamentals. In effect, you will wind up with a market cap index, albeit with different market capitalizations than now -- market capitalizations that will be the outcome of the fundamental factors chosen by the builders of the index. In effect, you will be running screens, but without the human judgment that is usually used to supplement such screens.

So we better hope that different investors choose funds following different fundamental indexes. But then how do they choose which fundamental index to use? Oh dear, I think we're back to the original problem.

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Re: the ongoing "active" vs "passive" debate

Post by ghariton » 26 Oct 2013 23:32

newguy wrote:Just think what it means when they say ~90% of traders lose money. It means the other 10% are getting all of it.
Nope. The brokers/advisers/salespeople get 80% of it. The other 10% might get 20%. Or maybe less.

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Re: the ongoing "active" vs "passive" debate

Post by ghariton » 26 Oct 2013 23:35

parvus wrote:
ghariton wrote:
ockham wrote:We already knew from Sharpe's simple market arithmetic that for any time period, some active managers will outperform.
Indeed. We know that, before fees and on a market-cap-weighted basis, half will over-perform and half will under-perform. After fees, well, just randomly, some will over-perform while the vast majority will underperform.
Yes well, that's around the median. Doesn't tell us much about the average though, does it? :wink:

(I'm speaking to newguy's point.)
No, it's a weighted mean, with weights equal to market caps -- or, if you prefer, an equal weight to every dollar invested.

(The word "average" is too vague to be useful, so I try not to use it.)

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Re: the ongoing "active" vs "passive" debate

Post by tidal » 27 Oct 2013 01:12

newguy wrote:
ghariton wrote:
ockham wrote:We already knew from Sharpe's simple market arithmetic that for any time period, some active managers will outperform.
Indeed. We know that, before fees and on a market-cap-weighted basis, half will over-perform and half will under-perform.
No, it means I'll outperform and the rest of you suckers will give me all your money.

Nothing from Sharpe contradicts me. Just think what it means when they say ~90% of traders lose money. It means the other 10% are getting all of it.
no, that's not what it means...
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Re: the ongoing "active" vs "passive" debate

Post by ghariton » 27 Oct 2013 02:02

Some lessons from the institutional world:
Data from 831 U.S. college and university endowments and affiliated foundations, representing over $400 billion in endowment assets, shows that the average return for U.S. college endowments was minus-0.3 percent in the 12 months ended in June 2012 (the most recent period for which data is available). Longer-term returns are not a lot better. College and university endowments returned an average of only 1.1 percent annually over the past five fiscal years and 6.2 percent over the past decade, net of fees. There is no way to sugarcoat those numbers.

<snip>

Research on the performance of institutional portfolios (not just endowment portfolios) shows that after risk adjustment, 24 percent of funds fall significantly short of their chosen market benchmark and have negative alpha, 75 percent of funds roughly match the market and have zero alpha, and well under 1 percent achieve superior results after costs—a number not statistically significantly different from zero. Mutual funds aren’t any better. In a random 12-month period, about 60 percent of mutual fund managers underperform. Lengthen the period to 10 and 20 years and the proportions of managers who underperform rises to about 70 percent and 80 percent, respectively. Perhaps even more importantly, money managers who underperform do so by roughly twice as much as the “outperforming” funds beat their chosen benchmarks.

<snip>

Clearly, the investment process is broken at the institutional level. The evidence is remarkably clear that institutions would have been better off doing nothing – partly on account of slightly better returns, but mostly on account of costs, particularly the costs of active management itself (which is far more expensive than passive management) and the costs of the consultants that recommended those managers in the first place. These consultants concede (as they must) that past performance is not indicative of future results. But they still make recommendations almost entirely due to such past performance. Why should anyone be surprised, then, when this approach fails (at least from the perspective of the institution, not the consultant)?
Why the reliance on past performance, indeed?

Securities regulators require, and funds and brokers regularly publish the mantra, that past performance is not a guide to the future. Yet the vast majority of investors tend to invest by extrapolating trends. Some even use past growth in dividends as an indicator.

Maybe it's better to throw darts, after all.

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Re: the ongoing "active" vs "passive" debate

Post by parvus » 27 Oct 2013 21:31

ghariton wrote:
parvus wrote:Thus, I'm intrigued by equal-weight and fundamental approaches, providing they can be had relatively cheaply.
On equal-weight approach, presumably you have to draw boundaries. All stocks traded on the TSE? Do you include all stocks traded on Ventures as well? OTC? Market cap weighting solves the problem in practice, because the small companies can effectively be ignored, or sparsely sampled.
You think that equal weighters and fundamentalists don't avail themselves of the same privileges their market-cap sistren have arrogated to themselves?

As for the fourth risk premia, illiquidity, I wonder who's going to build that index. :wink:
But if your index is equal weights, can you sample? If so, on what basis? If it is truly equal weights, is it the chimp's darts board, computerized? Or do you truly have to buy a piece of every company, even the very small ones? And if it is the latter, and a large number of investors opt for equal weights, will a whole bunch of funds be bidding for the same small companies? If so, won't that drive up their share price to stratospheric levels? Or does equal weights work only if a small fraction of investors adopt it?
Sources tell me that equal weights work best if stocks are of similar size, but inevitably there is a small-cap bias. So we move into rules-based territory.
On fundamental indexes, if many investors opt for the same fundamental index, that will drive up the share price of smaller companies with attractive fundamentals. In effect, you will wind up with a market cap index, albeit with different market capitalizations than now -- market capitalizations that will be the outcome of the fundamental factors chosen by the builders of the index. In effect, you will be running screens, but without the human judgment that is usually used to supplement such screens.
There's a problem? Where were the screens ante-Nortel?
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Re: the ongoing "active" vs "passive" debate

Post by Quebec » 28 Oct 2013 10:17

ghariton wrote:Some even use past growth in dividends as an indicator.
Indeed. I'd rather invest in a company with 10% dividend growth (with matching earnings and revenue growth) than invest in a company that has just cut it's dividend, is loosing money, etc. I also like companies with reasonable debt, payout ratios, in non-cyclical sectors, etc. There are no garantees that a portfolio of such companies will beat the market, but so far it's worked all right for me, especially during bear markets. (but most of our portfolio is indexed just in case I'm not such a good stock picker after all)

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Re: the ongoing "active" vs "passive" debate

Post by ghariton » 02 Nov 2013 12:31

Rawley Z. Heimer:
This paper is the first to provide empirical evidence that social interaction is more prevalent among active rather than passive investors. ... the odds of being an active investor increase by about twenty percent if the individual is social.... As suggested by Becker (1991), one’s financial wheeling and dealings may be a more robust topic of conversation than the strategy recommended by economists, buying and holding the market portfolio. Otherwise, why would investment clubs, such as those documented in Barber and Odean (2000a) continue to exist despite underperforming relative to a broad-based market index?
So investment clubs are bad for your financial health...

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Re: the ongoing "active" vs "passive" debate

Post by cannew » 02 Nov 2013 16:38

I think the question is Can I do better as an Active or Passive investor? I found out I could not and after I switched, I wonder why anyone would want to try to be an active investor.

From being a terrible trader, I happen to find an article about the Connolly Report strategy. After reading just his first sentence on investing, I realized there was a better way for me to invest and it's proven to be successful (again for me).

Everyone has to find their own method and one which achieves their goals over the long term (let's say 10 years, anything less may not provide a true picture if one is successful or not).

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Re: the ongoing "active" vs "passive" debate

Post by Peculiar_Investor » 05 Nov 2013 00:28

Bogle, at BH12, reiterated his viewpoint that the "active" vs "passive" debate is examining the issue from the wrong direction when looking at things from the efficient market hypothesis. His viewpoint is Whether Markets are More Efficient or Less Efficient, Costs Matter | Jack Bogle. As with many theories that originate and address the US markets, sometimes they travel well internationally and sometimes not so much.

As Canadians we are well aware of this challenge as our equity market is much more concentrated in three sectors, 72.9% as of 30-Sept-12 (Finance: 34.8%, Energy: 25.2% and Materials: 12.9%). This blog entry, The CMH (Cost Matters Hypothesis) | FT Long Short, is interesting as it comes from the European perspective and seems to confirm Bogle's viewpoint. Given the expense ratios changed in the Canadian mutual fund marketplace, it's pretty obvious to me that they fail Bogle's Cost Matters Hypothesis.

What still challenges my thinking is whether there are others factors, particular the high concentration of our "broad-based market cap-weight indexes" on just three sectors, that make passive investing in Canadian the best approach.

I have the time and interest in researching individual companies and consider myself buying parts of businesses, not just "stocks". As such, for the Canadian equities portion of our portfolios I've been successful with a buy and hold (keeping costs down) approach to stock picking. I'm not a diehard in this approach and continue to follow the indexing debate as it applies to the Canadian market with interest. For my young adult children's portfolio, I've advised them that as a starting position using a low-cost broad based Canadian index fund in a couch potato type portfolio is the correct approach.
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Re: the ongoing "active" vs "passive" debate

Post by Bylo Selhi » 05 Nov 2013 06:34

Using a "balanced" 40/20/20/20 portfolio, even the 73% concentration in Canada isn't as bad as it seems (73% of 20% = 15% of total portfolio.) That's still high but it's not alarming. If you believe Fama/French and/or the dividend growth folks then you can mitigate this further by buying and holding individual stocks. This also lets you benefit from the DTC, which of course you can't on the other 20/20 equities in your portfolio.

Bogle also once looked at buying and holding the top 50 stocks in the S&P500 as a substitute for buying and holding an S&P500 index fund. IIRC he found that after 25 years this would outperform the index fund by something like 50bp/year. Of course that's only a 25 year period (of generally high growth in stocks) so YMMV. I don't recall how much he paid in brokerage fees but these days with brokerages like IB I'd imagine they'd be substantially lower. OTOH there's a cost in time and effort to administer a portfolio of ~50 stocks, even if just to account for dividends, splits, mergers and such.
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Re: the ongoing "active" vs "passive" debate

Post by scomac » 05 Nov 2013 07:37

Peculiar_Investor wrote: I have the time and interest in researching individual companies and consider myself buying parts of businesses, not just "stocks". As such, for the Canadian equities portion of our portfolios I've been successful with a buy and hold (keeping costs down) approach to stock picking. I'm not a diehard in this approach and continue to follow the indexing debate as it applies to the Canadian market with interest. For my young adult children's portfolio, I've advised them that as a starting position using a low-cost broad based Canadian index fund in a couch potato type portfolio is the correct approach.
AS do I and this also applies to my wife's assets as I want those "set and forget it" should something happen to me. This doesn't mean that I have lost faith in what I do with respect to stock picking. It does, however reflect upon the reality of those who don't have the time or interest to pursue a more "active" approach and who knows, that just might include me at some future date.
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Re: the ongoing "active" vs "passive" debate

Post by Taggart » 05 Nov 2013 18:31

Special to The Globe and Mail
Published Monday, Nov. 04 2013, 7:52 PM EST
Last updated Tuesday, Nov. 05 2013, 1:28 PM EST

Three top stock picks from BBSL’s John DeGoey

Market outlook:

I reject all forms of prediction-based investing. Instead, I recommend that people use structured, market-based and evidence-based products and strategies. People should buy broadly-diversified investment products that cost little and have low turnover. Then, they should re-balance those periodically, but only when their overall mix is out of line with their targets.

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Re: the ongoing "active" vs "passive" debate

Post by NormR » 05 Nov 2013 18:48

Taggart wrote:I reject all forms of prediction-based investing. Instead, I recommend that people use structured, market-based and evidence-based products and strategies. People should buy broadly-diversified investment products that cost little and have low turnover. Then, they should re-balance those periodically, but only when their overall mix is out of line with their targets.
Just how much is John charging for his advice these days?

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Re: the ongoing "active" vs "passive" debate

Post by Taggart » 05 Nov 2013 19:01

NormR wrote:
Taggart wrote:I reject all forms of prediction-based investing. Instead, I recommend that people use structured, market-based and evidence-based products and strategies. People should buy broadly-diversified investment products that cost little and have low turnover. Then, they should re-balance those periodically, but only when their overall mix is out of line with their targets.
Just how much is John charging for his advice these days?
....and here I thought all value investors do not base their investments on future predictions. :)

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Re: the ongoing "active" vs "passive" debate

Post by parvus » 05 Nov 2013 20:12

Taggart wrote:
NormR wrote:
Taggart wrote:I reject all forms of prediction-based investing. Instead, I recommend that people use structured, market-based and evidence-based products and strategies. People should buy broadly-diversified investment products that cost little and have low turnover. Then, they should re-balance those periodically, but only when their overall mix is out of line with their targets.
Just how much is John charging for his advice these days?
....and here I thought all value investors do not base their investments on future predictions. :)
No, but at least trading and advisory costs are more or less predictable. :mrgreen:
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Re: the ongoing "active" vs "passive" debate

Post by scomac » 05 Nov 2013 22:42

parvus wrote:
Taggart wrote:
NormR wrote:
Just how much is John charging for his advice these days?
....and here I thought all value investors do not base their investments on future predictions. :)
No, but at least trading and advisory costs are more or less predictable. :mrgreen:
Yes and with John it will be 1.5% of AUM with a $400K minimum as I recall.
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Re: the ongoing "active" vs "passive" debate

Post by Taggart » 06 Nov 2013 03:13

parvus wrote:
No, but at least trading and advisory costs are more or less predictable. :mrgreen:
scomac wrote:

Yes and with John it will be 1.5% of AUM with a $400K minimum as I recall.
Yes, but an investor is not obigated to invest with this John. Even thirty years ago John Train used to talk about piggybacking on the advice of professionals without paying for their services.

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