The active versus passive investing debate has been raging for decades, and author Larry Swedroe is certainly not shy about what side of the argument he defends. In his book, The Quest for Alpha, Swedroe likens the Holy Grail of Christian mythology to alpha in financial management – the ability of money managers to deliver returns above their appropriate risk-adjusted benchmark. Swedroe goes on to explain how stock selection and market timing combine forces to form an art of active financial management and how this artwork, for the most part, is far too risky for individual investors. This is because any effort to exploit the market for a mispriced stock is a futile exercise. The market knows more than any individual investor will ever know on their own. The Quest for Alpha goes on to provide numerous examples to support this claim:
- A study by Marlena Lee of Dimensional Fund Advisors about the performance of over 2,300 bond funds from 1991-2008 revealed:
- “Actively managed bond funds underperformed by an amount roughly equal to fees.”
- “Collectively, investors in active bond funds lose about 90 basis points per year, or about $1.4 billion in 2008, in underperformance.”
- Successful streaks associated with great, active money management occur much longer than folks would typically believe, but these “hot hands” eventually get very cold: “For each of the 11 years 1974-1984, the Lindner Large-Cap Fund outperformed the S&P 500 Index. However, over the next 18 years, the S&P 500 Index returned 12.6 percent per annum. Believers in past performance as a prologue to future performance were awarded for their faith in the Fund…returns of just 4.1 percent, an underperformance of 8.5 percent per year for 18 years.”
- “By the end of 2005, Bill Miller’s streak of outperforming the S&P 500 Index had reached 15 years. Unfortunately for investors, that steak was broken in 2006 when the fund underperformed the S&P 500 Index by about 10 percent.” The book goes on to describe Miller’s underperformance in subsequent years: 2007 down by 12%; 2008 down by 18%.
Clearly in The Quest for Alpha, Swedroe defends passive money management. He also uses colleagues, industry experts and admissions from the financial industry to drive his point home:
- David F. Swensen who has been the chief investment officer of the Yale Endowment Fund since 1985, had this to say about mutual fund fees and performance: “Overwhelmingly, mutual funds extract enormous sums from investors in exchange for providing a shocking disservice. That is, mutual funds charge their investors big fees and usually fail to deliver returns that beat the market.”
- Warren Buffett (no explanation necessary) in his 1993 Annual Report: “By periodically investing in an index fund the know-nothing investor can actually outperform most investment professionals.”
- John Rekenthaler, the VP of research and product development at Morningstar, about identifying alpha: “We should have more answers.” “To be fair, I don’t think that you’d want to pay much attention to Morningstar’s star rating either.” This quote is quite the admission.
Swedroe goes on to discuss pension plans, and how they are slowly moving towards indexing equity assets. He also leverages wisdom from Nobel Prize winners who state “I make my money writing about the market, not participating in it.”
All of Swedroe’s writing is very compelling and makes for an interesting read for those who have ever questioned passive investing as a viable investment strategy. I’m personally convinced after fees, transaction costs, not to mention the laws of survivorship, even the most determined mutual fund picker over the long-term has no hope of alpha – they will never escape the inevitability of loses when compared to their benchmark index.
However, what had me a bit perplexed in Larry’s book was the minimal evidence of direct stock ownership, and long-term ownership at that, and its success rate over active fund management. Surely owning many blue-chip stocks directly for 30 years would have been more profitable than owning most mutual funds? I get that smart people makes mistakes. I also get most investors do not learn from their investing blunders and fail to see their investing bias. My point being, I read little in Swedroe’s book that alarmed me enough to immediately halt the other part of my retirement strategy, dividend investing. Swedroe highlights two very important factors throughout his book when it comes to losing the market-game: trading costs and taxes. What if I owned a few stocks whereby I could reinvest dividends that didn’t cost me a dime to do so? What if I owned these stocks in my Tax-Free Savings Account (TFSA) to avoid any tax on dividends paid or reinvested? What if owning these stocks, I received a (Canadian dividend) tax-credit for owning them even if they were not held in my TFSA or RRSP? Larry has a point, fees and taxes are a burden when it comes to active investing but this doesn’t mean companies that have paid shareholders for generations need to be discredited.
I liked Swedroe’s book. He reinforced many existing investing concepts and threw some new ones at me as well. His book was well written, full of examples and provided readers with some excellent ingredients to make a sound portfolio. However, in closing, I’m not sure if I need to have an all-indexed investment approach just yet. Swedroe told me “prudent investors don’t take more risk than they have the ability, willingness or need to take.” For now, I’m not.
Have you read Larry Swedroe’s The Quest for Alpha book yet? If so, what are your thoughts on it?